Pricing Sovereign CDS with Switching Regimes

Description

Recent financial crisis highlights the importance of sovereign credit risk. We have witnessed the strong reactions of other financial markets to the news of CDS markets. Casual observation seems to suggest that there is a regime change in the sovereign CDS markets at the beginning of the current crisis since the sovereign CDS spread across many countries widened so much. However, the existing sovereign CDS models, e.g., Pan and Singleton (2008) and Ang and Longstaff (2011), usually assume that the default risk of a sovereign entity follows some continuous processes, the role of regime shifts is ignored. Thus, studies of the sovereign CDS markets based on these models might yield misleading results both quantitatively and qualitatively. We intend to fill this gap in this study to build a sovereign CDS pricing model with switching regimes.