Abstract
PurposeThe credit ratings issued by the Big 3 ratings agencies are inaccurate and slow to respond to market changes. This paper aims to develop a rigorous, transparent and robust credit assessment and rating scheme for sovereigns.Design/methodology/approachThis paper develops a regression-based model using credit default swap (CDS) data, and data on financial and macroeconomic variables to estimate sovereign CDS spreads. Using these spreads, the default probabilities of sovereigns can be estimated. The new ratings scheme is then used in conjunction with these default probabilities to assign credit ratings to sovereigns.FindingsThe developed model accurately estimates CDS spreads (based on RMSE values). Credit ratings issued retrospectively using the new scheme reflect reality better.Research limitations/implicationsThis paper reveals that both macroeconomic and financial factors affect both systemic and idiosyncratic risks for sovereigns.Practical implicationsThe developed credit assessment and ratings scheme can be used to evaluate the creditworthiness of sovereigns and subsequently assign robust credit ratings.Social implicationsThe transparency and rigor of the new scheme will result in better and trustworthy indications of a sovereign’s financial health. Investors and monetary authorities can make better informed decisions. The episodes that occurred during the debt crisis could be avoided.Originality/valueThis paper uses both financial and macroeconomic data to estimate CDS spreads and demonstrates that both financial and macroeconomic factors affect sovereign systemic and idiosyncratic risk. The proposed credit assessment and ratings schemes could supplement or potentially replace the credit ratings issued by the Big 3 ratings agencies.
Highlights
It became evident during the credit crisis of 2008 that there were several major issues with sovereign credit ratings issued by the Big 3 (S&P, Moody’s and Fitch)
As was evidenced during the financial crisis, the ratings assigned by the Big 3 are slow to respond to market changes
Given the vital role played by sovereign credit ratings, there is an urgent need for a transparent and rigorous model that can assess the creditworthiness of a sovereign and assign ratings that are accurate and respond quickly to market changes
Summary
It became evident during the credit crisis of 2008 that there were several major issues with sovereign credit ratings issued by the Big 3 (S&P, Moody’s and Fitch). Our framework uses the multi-factor affine model developed by Ang and Longstaff (2013) to study sovereign credit risk of Eurozone countries using CDS spreads. Calibration outcome for the one-year maturity CDS spread of France several explanatory variables that are independent, different models for each country have been tested using lagged time series. The R-squared values are between 0.662 and 0.845, which indicates that a significant portion of both the systemic risk and the idiosyncratic risk intensity process can be explained by financial and macroeconomic data. Note that the actual data of the macroeconomic variables over the testing period have been used, in which the estimated l and z values are used as input for the CDS spread calculation.
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