Modeling Sovereign Credit Risk with Credit Ratings

The recent global financial crisis has highlighted the important role played by credit rating agencies in world credit markets. We have witnessed extensive media coverage of downgrades of sovereign governments (including even the strongest borrower, the US government) by rating agencies and violent reactions to these downgrades from sovereign CDS markets. Rating changes could represent a discrete and material change of the credit quality of a borrower. Moreover, rating downgrades could seriously affect market’s perception of the credit quality of a borrower and limit its access to capital. Therefore, credit rating could have a nontrivial or even first order effect on the borrowing cost of a sovereign entity.Unfortunately, the existing academic literature on sovereign credit risk has mainly focused on modeling continuous evolution rather than discrete change of the credit quality of a sovereign borrower. For example, the reduced-form sovereign credit risk models of Pan and Singleton (2008), Ang and Longstaff (2011) and others typically assume that the default intensity of a sovereign borrower follows a continuous-time diffusion process and completely ignore the role played by ratings. However, in today’s volatile markets with constant changes in the fortunes of nations, existing models might not be able to completely capture the default risk of sovereign borrowers and could yield misleading conclusions, both quantitatively and qualitatively, in studies of sovereign credit markets.Our project bridges the gap in the literature by developing a continuous-time model of sovereign default risk with credit ratings. Our model explicitly distinguishes between two important components of sovereign credit risk: the risk of default and the risk of credit rating changes. Our model provides a rich and yet tractable characterization of the term structure of CDS spreads and will shed new light on the role of credit ratings in determining sovereign CDS spreads. We plan to conduct a rigorous econometric analysis of the model using sovereign CDS data. Our modeling approach makes it possible to investigate the role played by rating agencies during the financial crisis in a systematic way through the sovereign CDS markets. We can potentially answer some of the important questions regarding the rating agencies: their relevance, usefulness and accuracy in assessing sovereign credit risk.