Measuring and Analyzing Sovereign Risk with Contingent Claims
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Measuring and Analyzing Sovereign Risk with Contingent Claims MICHAEL GAPEN, DALE GRAY, CHENG HOON LIM, and YINGBIN XIAO This paper develops a comprehensive new framework to measure and analyze sovereign risk. Contingent claims analysis is used to construct a marked-tomarket balance sheet for the sovereign and derive a set of forward-looking credit risk indicators that serve as a barometer of sovereign risk. Applications to 12 emerging market economies show the approach to be robust, and the risk indicators are a significant improvement over traditional macroeconomic vulnerability indicators and accounting-based measures. The framework can help policymakers design risk mitigation strategies and rank policy options using a calibrated structural model unique to each economy. [JEL E61, G13, G15, H63] IMF Staff Papers (2008) 55, 109–148. doi:10.1057/palgrave.imfsp.9450026; published online 22 January 2008
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s economies have become more reliant on private capital flows, they have also become more vulnerable to the volatility of capital flows and associated market, liquidity, and credit risk. A comprehensive framework of
Michael Gapen is an economist with the IMF Institute; Dale Gray is a senior economist and Cheng Hoon Lim is a division chief with the IMF Monetary and Capital Markets Department; and Yingbin Xiao is an economist with the IMF European Department. The authors would like to thank Zvi Bodie, Carlos Medeiros, Robert Merton, Linda Tesar, and participants of the JPMorgan Chase seminars at the 2005 Annual Meetings of the InterAmerican Development Bank in Okinawa and the Asian Development Bank in Istanbul, the Institute of International Finance Country Risk Workshop, and the IMF Institute for helpful comments and suggestions. We would also like to thank an anonymous referee for helpful suggestions.
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Michael Gapen and others
risk identification and management is needed to analyze—and hopefully help prevent—large-scale capital account crises and associated financial distress. A useful approach that has been gaining popularity since the Asian crisis is to assess the risk posed by potentially unstable positions in sectoral balance sheets, including the corporate, financial, and public sectors. Shocks to interest rates, exchange rates, or market sentiment that bring about a deterioration in the value of a sector’s assets compared to its liabilities lead to a reduction in net worth. In an extreme case, net worth turns negative and the sector may become insolvent, triggering widespread distress and transferring risk across balance sheets. Risk transfer can be ‘‘bottom-up’’ from the corporate sector to the banking system and ultimately to the sovereign balance sheet, as was the case during the Asian crisis, or it can be ‘‘topdown,’’ as was seen more recently in Latin America. Developing an effective approach to detect and assess balance sheet vulnerabilities before they become severe is essential to minimize risks and protect the stability of the overall economy. The main purpose of this paper is to show how moder
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