A Structural Approach to Estimate Market-Assessed Sovereign Credit Risk

Abstract

This paper explores the economic determinants of market-assessed sovereign risk of members of the European monetary union. The empirical work is innovative in its Merton structural specification of appropriate inputs. It provides a theoretical background for the empirical investigation of sovereign risks. We make use of publicly available government financial statistics as well as national stock market volatility estimated by EGARCH, implied from traded options and by fitting a generalized Pareto distribution. We show a high degree of association between our modelled spreads and credit default swap spreads using volatility estimates based on option implied and generalized Pareto distribution. Model performance holds in out-of-sample prediction and the non-linear model derived from structural theory is shown to outperform a benchmark linear regression model.

These results provide policy makers and regulators with a set of insights into the factors which influence credit market activity enabling them to take an informed approach to policy and regulatory settings which will be subject to market appraisal.

Keywords: Sovereign credit risk, credit default swap, structural model

JEL Classification: G01, G10