Sovereign credit risk in a hidden Markov regime-switching framework. Part 1: methodology

Louise Potgeiter () and Gianluca Fusai ()
Additional contact information
Louise Potgeiter: Cass Business School, City University, http://www.cass.city.ac.uk/
Gianluca Fusai: DiSEI U. of Piemonte Orientale, http://www.eco.unipmn.it

Journal of Financial Transformation, 2013, vol. 37, 99-109

Abstract: Standard approaches to estimating credit default probability estimation have certain drawbacks, most importantly regarding the underestimation of the true default probability which remains an undesirable property in sovereign risk management. As an alternative, this research applies a discrete-time Markov-modulated model to default probability estimation and applies it to Merton’s contingent claims approach, offering an attractive combination of possibly resolving the underestimation inherent in most standard structural models with a more conservative approach when predicting valuable information from a sovereign’s economic balance sheet. The crucial advantage of the estimation is that it backs the hypothesis that a regime-switching framework that allows for structural shifts can substantially improve default risk estimators, and proves that the methodology can be tractably extended to a contingent claims approach. Moreover, there are likely practical situations with certain policy implications when the predictions of the model could be used to detect systematic sovereign risk.

Keywords: sovereign credit risk; credit risk; Markov model; Markov framework; credit default probability; regime-switching; sovereign risk (search for similar items in EconPapers)
JEL-codes: G21 G32 (search for similar items in EconPapers)
Date: 2013
References: Add references at CitEc
Citations:

There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ris:jofitr:1558

Access Statistics for this article

Journal of Financial Transformation is currently edited by Prof. Shahin Shojai

More articles in Journal of Financial Transformation from Capco Institute 77 Water Street, 10th Floor, New York NY 10005.
Bibliographic data for series maintained by Prof. Shahin Shojai ( this e-mail address is bad, please contact ).