MODELING SOVEREIGN RISKS: FROM A HYBRID MODEL TO THE GENERALIZED DENSITY APPROACH

Ying Jiao and Shanqiu Li

Mathematical Finance, 2018, vol. 28, issue 1, 240-267

Abstract: Motivated by the European sovereign debt crisis, we propose a hybrid sovereign default model that combines an accessible part taking into account the evolution of the sovereign solvency and the impact of critical political events, and a totally inaccessible part for the idiosyncratic credit risk. We obtain closed†form formulas for the probability that the default occurs at critical political dates in a Markovian setting. Moreover, we introduce a generalized density framework for the hybrid default time and deduce the compensator process of default. Finally, we apply the hybrid model and the generalized density to the valuation of sovereign bonds and explain the significant jumps in long†term government bond yields during the sovereign crisis.

Date: 2018
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