A Rating-Based Sovereign Credit Risk Model : Theory and Evidence

We develop a rating-based continuous-time model of sovereign credit risk with closed-form solutions for a wide range of credit derivatives. In our model, rating transition follows a continuous-time Markov chain, and countries with same credit rating share similar level of default risk. A parsimonious version of our model, with only 16 parameters, one common and one country-specific factor, can simultaneously capture the term structure of CDS spreads of 34 in-sample and 34 out-of-sample countries well. On average, the common factor explains more than 60% of the variations of the CDS spreads of both the in-sample and out-of-sample countries, and 80% of the variations of the common factor is explained by the CBOE VIX index, the 5-year US Treasury rate, and the CDX NA IG Index.