9th Symposium on Finance, Banking, and Insurance
Universität Karlsruhe (TH), Germany, December 11 - 13, 2002

Abstract

Country Risk-Indicator

A. Karmann, M. Plate

Technische Universität Dresden

As the Brady bond market indicates, USD bonds issued by different debtor nations show seemingly different interest rates. The conventional cost-oriented approach, to identify the spread as a compensation for default plus some other market premium, lacks clear advices to infer default probabilities. Alternatively, an arbitrage-oriented reasoning argues that the spread is the price of an insurance contract against default, materialized by a put option on the sovereign`s ability to pay back outstanding debt in foreign currency at the expiration date.

To identify the (lognormal) process of (free) foreign reserves of a debtor nation, we use spread data of bonds as well as fundamental economic data to infer for µ and s. The applicability of our approach to identify market based default probabilities is shown for emerging market examples (Latin America, Eastern Europe).