Sovereign Default Risk Assessment From The Bottom-Up

In 2010, the world’s focus on the global financial crisis shiftedfrom financial markets and institutions to sovereign debt, especially inEurope. This has motivated a re-examination of techniques andtraditional indicators to assess the health of individual countries.Since the potential financial and economic implosion of several Europeancountries seemed to erupt fairly quickly, one might conclude that theexisting scholarly and practitioner methods were not adequate. Webelieve that one can learn a great deal about sovereign risk by, inaddition to observing traditional macroeconomic measures of performance,to also carefully assess the health and aggregate default risk of anation’s private corporate sector - - a type of“bottom-up” analysis. Models such as Altman’s originalZ-Score technique and more recently, the Z-Metrics’ risk system,can provide important early warning measures of sovereign vulnerability.This study does just that by analyzing the Z-Metrics’ medianprobability of default (PD) of nine European countries and the USA fromtwo time periods prior to the clear recognition of serious financialdifficulties in the Eurosector. Our measures of PDs are also compared tothe implied probability of default from a prominent market indicator,the credit default swap market, with both general confirmation and somesurprising results.