Sovereign Correlations in Recent Recessions

by Taehan Bae of University of Regina, and
Ian Iscoe of Algorithmics Inc, an IBM Company

March 2012

Abstract: The creditworthiness of a corporate counterparty in a credit portfolio can be estimated or proxied by the equity value and the outstanding debts. For sovereign assets, however, it is not straightforward to measure the creditworthiness in this manner, due to the lack of reliable data. We describe a simple but effective method to estimate the unknown sensitivities to a systemic factor in a single-factor creditworthiness index model, based on the estimated time series of risk-neutral probabilities of default which are calibrated from historical sovereign CDS spreads. Empirical results are given with a focus on the recent recessionary periods in Europe.

JEL Classification: C51, G15.

Keywords: sovereign assets, creditworthiness index, CDS spread, risk-neutral probability of default, credit drivers.

Published in: International Review of Applied Financial Issues and Economics, Vol. 4, No. 1, (March 2012), pp. 11-21.

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