Assessing sovereign default risk: A bottom-up approach

Feng Liu, Egon Kalotay and Stefan Trück
Authors registered in the RePEc Author Service: Stefan Trueck ()

Economic Modelling, 2018, vol. 70, issue C, 525-542

Abstract: This study assesses sovereign default risk of individual U.S. states utilizing information about default risk at the company level. We link integrated risk factors of the private sector to the overall sovereign risk of state governments in conjunction with additional financial variables. Using data on Moody’s KMV expected default frequencies (EDFs) on corporate default risk, we derive credit risk indicators for different industries. Building on these measures, we then develop state level credit risk indicators encompassing industry compositions to explain the behaviour of credit default swap (CDS) spreads for individual states. We find that market-based measures of private sector credit risk are strongly associated with subsequent shifts in sovereign credit risk premiums, as measured by CDS spreads. The developed credit risk indicators are highly significant in forecasting sovereign CDS spreads at weekly and monthly sampling frequencies. Overall, our findings suggest a strong predictive link between market expectations of private sector credit quality and expectations of sovereign credit quality - a connection that is not directly discernible from scoring models.

Keywords: Sovereign credit risk; Default risk; CDS spreads; Expected default frequencies (EDFs) (search for similar items in EconPapers)
JEL-codes: G12 G17 G32 (search for similar items in EconPapers)
Date: 2018
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:70:y:2018:i:c:p:525-542

DOI: 10.1016/j.econmod.2017.09.013

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