| The paper presents a methodology to price the risk of default of a sovereign issuer based on the underlying state variable process. The approach is based on a numerically tractable version of the model pioneered by Madan and Unal in “Pricing the Risks of Default”, working paper. Madan and Unal use Poisson specification in combination with a default-triggering threhold of the state variable in order to describe default process on corporate debt: the probability of default depends on how far the state process is away from the boundary and is necessarily equal to one once the boundary is triggered. Their specification of the state variable dynamics does not allow for the model to be applied to the soverign debt and is based on short maturity data only. Unlike that of Madan and Unal, our model can be used in the emerging markets environment, since we allow for a more general dynamics of the fundamental process, and can be estimated using data on bonds of arbitrary maturity. In particular, we study the term-structure of the no default probability and find that allowing for mean-reversion in the risk-neutral drift specification of the state variable substantially improves the cross-sectional fit of the model. We also illustrate how the model can be used to make an assessment about the future of the underlying economy from the defaultable securities price data. |
