The Asian Institute of Chartered Bankers has just published “A Best Practice Approach to Modeling Sovereign Defaults” in the December 2014 issue of its Banking Insight magazine. Since the article, which I co-authored with my colleagues Suresh Sankaran and Dr. Clement Ooi, was targetted toward the Asia market, it is helpful to emphasize some of the most important points in modeling sovereign default risk from a world-wide perspective. There are three key points in modeling sovereign default risk that we explain in the rest of this article:
- The credit default swap market is a very problematic source of credit information and, at best, it is reliable only for a short list of reference names.
- The conflict of interest faced by legacy rating agencies is even more extreme in the sovereign case than it is in the well-documented corporate and structured products markets.
- Modern statistical modeling techniques are best practice and the only realistic alternative to the credit default swap market and legacy credit ratings.
We outline the reasons for these assertions in the rest of this note. Read more