Sovereign Risk in a Structural Approach - Evaluating Sovereign Ability-to-Pay and Probability of Default

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Sovereign Risk in a Structural Approach - Evaluating Sovereign Ability-to-Pay and Probability of Default

by Alexander Karmann of the Dresden University of Technology, and
Dominik Maltritz of the Dresden University of Technology

October 10, 2002

Abstract: We quantify the probability that a sovereign defaults on repayment obligations in foreign currency. Adopting the structural approach as first introduced by Merton, we consider the sovereign's ability-to-pay, characterised by the sum of discounted future payment surpluses, as the underlying process. Its implicit volatility is inferred from market spreads. We demonstrate for the case of Latin America and Russia that our approach indicates default events well in advance of agencies and markets.

JEL Classification: F34.

Keywords: Sovereign risk, Probability of default.

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