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Forecasting sovereign default risk with Merton’s model

Forecasting sovereign default risk with Merton’s model

15-10-2015 | Investigación
We provide an extensive empirical study into the Gray, Merton, and Bodie (2007) structural model for sovereigns. We show that the structural approach for emerging countries that issue both local- and foreign currency-denominated debt has its merits.

Speed read:

  • We look how fast CDS spreads react to changes in model in- and outputs
  • CDS spread changes strongly correlate with exchange rate returns
  • But CDS spread changes on average react with a delay to changes
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Merton’s structural model for sovereigns is proven to be useful to analyze the default risk of a country. In this paper,1 we are the first to investigate how fast CDS spreads react to changes in model inputs and outputs.

CDS spread changes strongly correlate with exchange rate returns, which are an input to the model. But CDS spread changes on average react with a delay to changes in model outputs such as the distance to default, the default probability, and model spreads. Hence, contingency claim analysis for sovereigns provides useful predictions for CDS spreads.

1 Duyvesteyn, J. and Martens, M., 2015, ‘Forecasting sovereign default risk with Merton’s model’, The Journal of Fixed Income.

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