Venue: Seminar Hall 1
Abstract: This paper proposes a modified contingent claims model that incorporates the priority structure of creditors to measure and monitor sovereign credit risk in five peripheral euro area countries during the period 2000Q1-2016Q3. Unlike traditional indicators of sovereign risk, the sovereign distance-to-default (DtD) indicator that we propose, not only uses market based measures, but also information from the public sector balance sheets to better isolate sovereign credit risk. By analyzing and comparing the behavior of sovereign DtD with three of the most relevant traditional market-based indicators (CDS spreads, sovereign yield spreads and credit rating), our results indicate that the proposed sovereign risk indicator shows better predictive ability than traditional ones and, in contrast with the latter, it is mainly driven by macroeconomic fundamentals rather than market sentiment variables. Therefore, it presents a meaningful signaling power in assessing sovereign vulnerabilities.