Measuring and Analyzing Sovereign Risk with Contingent Claims

As economies have become more reliant on private capital flows, they have also become more vulnerable to the volatility of capital flows, and to price and other shocks. A comprehensive framework is needed to analyze and hopefully help prevent large scale capital account crises and associated financial distress. A useful approach that has been gaining popularity since the Asian crisis is to assess the risk posed by potentially unstable positions in sectoral balance sheets, including in the corporate, financial, and public sectors.

Shocks to interest rates, exchange rates, or market sentiment that bring about a deterioration in the value of a sector’s assets compared to its liabilities lead to a reduction of its net worth. In the extreme case, net worth turns negative and the sector may become insolvent. In these cases, risks are transferred across balance sheets, triggering widespread distress.

Risk transfer can be “bottom-up” from the corporate sector to the banking system and ultimately to the sovereign balance sheet, as was the case during the Asian crisis, or it can be “top-down,” as was seen more recently in Latin America. Developing an effective approach to detect and assess balance sheet vulnerabilities before they become severe is essential to minimize risks and protect the stability of the overall economy.

In this paper, the contingent claims approach (CCA) is used to measure and analyze risk on the public sector, or sovereign, balance sheet. Estimating risk using such an approach has a long tradition in modern financial theory and has been widely applied in the analysis of corporate sector credit risk. It is increasingly being used to estimate risk in the financial sector, but has yet to be broadly applied at the sovereign level. This paper represents a first step in this direction.

Contents

I. Introduction
II. A Practical Approach to Sovereign Risk

A. Defining Sovereign Distress: The Concept
B. Estimating the Value of Sovereign Assets

III. Contingent Claims Analysis of the Sovereign Balance Sheet

A. Consolidating the Sovereign Balance Sheet
B. Seniority of Consolidated Balance Sheet Liabilities
C. Calculating Implied Sovereign Asset Value and Volatility

V. Robustness of Sovereign Credit Risk Indicators

A. Correlation with Market Data
B. Regression Analysis

VI. Scenario and Simulation Analysis: Hypothetical Sovereign