A ratings‐based approach to measuring sovereign risk

TLDR

The study proposes a new approach to measuring sovereign default risk and seeks to improve understanding of how sovereign credit rating teams assess long‑term country risks for emerging market investments. The authors construct a ratings‑implied expected loss measure using sovereign credit ratings and historical default rates, then compare it to standalone ratings and analyze its relationship with credit default swap spreads. The ratings‑implied expected loss measure proves more informative for sovereign risk assessment and provides additional support for debt‑intolerance and original‑sin explanations of country risk, highlighting the value of credit rating teams. © 2007 John Wiley & Sons, Ltd.

Abstract

Abstract We propose a new approach to measuring sovereign default risk. We use sovereign credit ratings and historical default rates provided by credit rating agencies to construct a measure of ratings‐implied expected loss. We compare our measure of expected loss from sovereign defaults with stand‐alone credit ratings and also examine its relationship with credit default swap spreads. We show that our measure is more informative for measuring sovereign risk. We re‐examine the fundamental determinants of sovereign risk and find further evidence to support the debt intolerance and original sin explanations for country risk. This study contributes an improved understanding of the value of sovereign credit rating teams in assessing the long‐term country risks accompanying emerging market investments. Copyright © 2007 John Wiley & Sons, Ltd.