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528
JOIM 2007
JOIM
www.joim.com
0 Introduction
Vulnerability of a national economy to volatility in
the global markets for credit, currencies, commodities, and other assets has become a central concern
a
Sr. Risk Expert, Monetary and Capital Markets Dept., International Monetary Fund, and President of MF Risk, Inc.
E-mail: dgray@imf.org and dgray@mfrisk.com.
b
expected return in the distribution. This riskneutral distribution is the dashed line in Figure
1(b) with expected rate of return r, the risk-free
rate. Thus, the risk-adjusted probability of default
calculated using the risk-neutral distribution is
larger than the actual probability of default for all
assets which have an actual expected return ()
greater than the risk-free rate r (that is, a positive
risk premium).5 This is illustrated in Figure 1(b)
which shows that the area below the promised payments of the risk-neutral distribution (dashed
line) is larger than the area below the promised
payments of the actual distribution (solid
line).
The calculation of the actual probability of default
is outside the CCA/Merton Model but it can be
combined with an equilibrium model of underlying asset expected returns to produce estimates that
are consistent for expected returns on all derivatives,
Asset Value
Asset Value
Expected Asset
Drift of
Expected Asset
Drift of
A0
Promised Payments
A0
Actual
Probability
of Default
Promised Payments
Drift of r
Actual
Probability
of Default
Time
Risk-Adjusted Probability
of Default
Time
(a)
(b)
The value of assets at time t is A(t). The asset return process is dA/A = A dt + A t, where A is the drift rate or asset return, A is equal
to the standard deviation of the asset return, and is normally distributed, with zero mean and unit variance. The probability distribution at
time T is shown in (a).
Default occurs when assets fall to or below the promised
payments, Bt . The probability of default is the probability that At Bt which is:
Prob(At Bt ) = Prob(A0 exp [(A A2 /2)t + A t] Bt ) = Prob( d2, ). Since : N (0, 1), the actual probability of default is
N ( d2, ), where d2, =
.
A t
Shown in (b) is the probability distribution (dashed line) with drift of the risk-free interest rate, r.
Risk adjusted probability of default is N ( d2 ), where d2 =
.
A t
Box. 1
Merton Model Equations for Pricing Contingent Claims
The total market value of assets at any time, t, is equal to the market value of the claims on the assets, equity and risky debt
maturing at time T :
Assets = Equity + Risky Debt
A(t) = J (t) + D(t)
Asset value is stochastic and in the future may decline below the point where debt payments on scheduled dates cannot be
made. The equity can be modeled and calculated as an implicit call option on the assets, with an exercise price equal to
the promised payments, B, maturing in T t periods. The risky debt is equivalent in value to default-free debt minus a
guarantee against default. This guarantee can be calculated as the value of a put on the assets with an exercise price equal
to B.
Risky Debt = Default-Free Debt Debt Guarantee
D(t) = Be r(T t) P(t)
We omit the time subscript at t = 0.
The value of the equity is computed using the Black-Scholes-Merton formula for the value of a call:
J = AN (d1 ) Be rT N (d2 )
+
r+
B
d1 =
d2 = d1 T ,
ln
A
2
2
T
0.8
30
0.6
20
0.4
10
0.2
40
Put Option Value
0
0
10
20
30
40
50
60
70
80
90
10
Asset Value
(Note: Strike =40, Asset Volatility=40%)
Put Value (LHS)
Assets
Liabilities
Guarantees
Foreign Reserves
Foreign-currency Debt
Net Fiscal Asset
Local-currency Debt
Other Public Assets
Base Money
10
ASSETS
LIABILITIES
International Reserves
Value of Local-currency
Liabilities, in Foreign
Currency Terms
[ = Local-currency Debt
+ Base Money ]
11
Foreign-currency debt
12
13
14
MLC base money in local currency terms; rd domestic interest rate; rf foreign interest rate; domestic
currency denominated debt is Bd (derived from
the promised payments on local-currency debt
and interest payments up to time t); XF forward
exchange rate; XF volatility of forward exchange
rate; Dd volatility of domestic debt in local currency terms; Dd ,XF correlation of forward exchange
rate and volatility of domestic debt in local currency terms; M , Dd $ correlation of money (in
foreign currency terms) and local-currency debt
(in foreign currency terms); MLC volatility of
money (in local currency terms); M volatility
of money (in foreign currency terms); and Dd $
volatility of local-currency debt (in foreign currency
terms).
(3)
(4)
Since local-currency liabilities have some similarities to shares, the value of money and localcurrency debt times the exchange rate is like the
market cap of the sovereign. The volatility of the
local-currency liabilities comes from the volatility
of the exchange rate and the volatility of the quantities of money and local-currency debt (issued or
repurchased).
Value of local-currency liabilities in foreign currency terms, LCL$ , is a call option of sovereign
assets in foreign currency terms, V$Sov , with its
strike price tied to the distress barrier for foreigncurrency denominated debt Bf derived from the
promised payments on foreign-currency debt and
interest payments up to time t.
LCL$ = V$Sov N (d1 ) Bf e rf T N (d2 )
(5)
The formula for the value of local-currency liabilities in foreign currency terms is
(MLC e rd T + Bd )e rf T
XF
(6)
The volatility of the local-currency liabilities is
LCL$ = M + Bd $,t=0 =
$LCL = f (M , Bd , rd , M , d , XF , XF ,
Dd ,XF , M ,Dd $ ),
(7)
(8)
(9)
15
4 Application to countries
Using the calibration technique described above,
the implied market value of sovereign assets and
implied volatility of sovereign assets were calculated
on a weekly frequency. The risk indicators were also
calculated. Figure 5 shows the model risk indicator (risk-neutral default probability) compared to
credit default swap (CDS) spreads on sovereign
foreign-currency debt. Note that CDS or bond
credit spreads were not used as inputs into the calculation of the risk indicator. As can be seen in
Figure 5 the risk indicator has a high correlation
with sovereign spreads.
Robustness checks suggest that the distance-todistress, model credit spread, and risk-neutral
probability of default are useful for evaluating
sovereign vulnerabilities (Gapen et al. 2005). The
evidence indicates that the book value of foreigncurrency liabilities along with market information
from domestic currency liabilities and the exchange
rate contain important information about changes
in the value of foreign-currency liabilities and credit
risk premium. The nonlinearities and inclusion of
volatility in the option pricing relationship used
in this analysis contributes to the high degree
of explanatory power and correlation with actual
data.20
The sovereign distance-to-distress (d2 ) to CDS
spreads for 11 countries in 20022004 period
4500
35
4000
30
3500
3000
25
2500
20
35
1350
30
1150
25
950
20
750
15
550
2000
10
350
10
1000
150
500
-50
15
28
/
8/ 02
23
10 / 02
/1
8
12 /0 2
/1
3/
0
2/ 2
7/
03
4/
4/
03
5/
30
/
7/ 03
25
/0
9/ 3
19
/
11 03
/1
4/
0
1/ 3
9/
04
6/
Ju
n04
Se
p04
D
ec
-0
4
130
14
90
12
110
10
90
80
50
50
40
30
10
0
12
/2
7/
02
4/
5/
5/ 02
31
/
7/ 02
26
/0
9/ 2
20
11 /02
/1
5/
1/ 0 2
10
/0
3/ 3
7/
0
5/ 3
2/
0
6/ 3
27
/
8/ 03
22
10 /03
/1
7
12 /0 3
/1
2/
0
2/ 3
6/
04
60
30
20
10
0
6/
13
/0
3
8/
8/
03
10
/3
/0
3
11
/2
8/
03
1/
23
/0
4
70
70
2/
21
/0
3
4/
18
/0
3
Basis Points
300
160
14
14
140
12
12
120
10
100
80
60
40
20
250
200
10
8
150
6
100
4
2
50
12
/2
9/
0
2/ 2
9/
0
3/ 3
23
/0
3
5/
4/
0
6/ 3
15
/
7/ 03
27
/0
3
9/
7/
10 03
/1
9
11 /0 3
/3
0/
0
1/ 3
11
/0
2/ 4
22
/0
4
4/
4/
04
Basis Points
16
10
/4
11 /02
/2
9/
0
1/ 2
24
/0
3/ 3
21
/0
5/ 3
16
/0
7/ 3
11
/0
3
9/
5
10 /03
/3
1
12 /0 3
/2
6/
0
2/ 3
20
/0
4
Basis Points
Ju
n03
Se
p03
D
ec
-0
3
M
ar
-0
4
Ju
n02
Se
p02
D
ec
-0
2
M
ar
-0
3
1500
Basis Points
Basis points
16
Figure 5 Risk indicators from sovereign CCA model compared to market spreads.
Source: MFRisk model and Bloomberg.
17
1500
1000
2
R = 0.80
500
0
0
0.5
1.5
2.5
3.5
Distance to Distress
500
450
Billion US $
400
350
300
250
200
150
100
50
0
11
/5
/2
00
5/
1
24
/2
00
2/
10 2
/2
00
2
6/
28
/2
00
1/
3
14
/2
00
4
8/
1/
20
0
2/
17 4
/2
00
5
9/
5/
20
0
3/
24 5
/2
00
6
18
80%
100%
60%
Volatility
Volatility
80%
40%
20%
60%
40%
20%
400
350
300
250
200
150
0%
100
0%
0
0.1
350
300
250
200
150
0.2
0.3
0.4
0.5
FX Forward ($/R)
100
0
2000
3000
4000
0.2
0.3
0.4
0.5
1000
Basis Points
1000
0.1
2000
3000
4000
Figure 8 Nonlinear changes in value and volatility of sovereign assets, foreign exchange rates, credit
spreads, and domestic interest rates in the case of Brazil 20022005.
Source: MFRisk model and Bloomberg.
20003000 basis points) correspond to a lower
(more depreciated) forward exchange rate.
5 Applications of sovereign CCA from the
perspective of investors23
Investors can apply sovereign CCA framework in
numerous ways. First, it provides a relative value
framework for the contingent claims on sovereign
assets and can be a helpful tool in sovereign relative value trading or what can be called sovereign
capital structure arbitrage. Second, CCA has important implications for the rapidly growing area of
sovereign wealth funds. Emerging market governments have amassed large reserves and many governments have or are setting up sizeable sovereign
wealth funds. The CCA framework developed here
JOURNAL OF INVESTMENT MANAGEMENT
19
20
Initial
state
Final
state
Prot
or Loss
0.23
100
112
202
56%
14%
0.30
100
146
239
45%
3%
2326
2990
3030
690
705
2300
Total
3005
on the CDS trade. There are a myriad of possible strategies. Convergence arbitrage is one strategy
if model fair values diverge from observed levels
and the bet is that they will converge over a certain horizon period. Volatility trades are possible
as well.
Preliminary work shows that the skew from FX
options and its relation to sovereign CDS spreads
has parallels to the relation between equity option
skew and corporate CDS spreads seen in corporate
capital structure analyses/models. Many of the
strategies designed for corporate capital structure
trades can be adapted to sovereign capital structure
and relative value trades.
In a broader economic setting, the economy-wide
CCA balance sheet model incorporating the nancial and corporate sectors can be utilized to design
relative value and other trading strategies. These can
be extended to stock indexes, individual stocks of
rms or banks and interest rate derivatives. There
are a variety of trading strategies including international positions in other countries and in the
S&P, VIX, foreign bonds, etc. The sovereign CCA
framework has also recently been extended to value
sovereign local-currency debt. This extension can
be included in trading strategies.24
21
can be viewed as a sovereign portfolio consisting of assets, liabilities, and contingent liabilities
(whose values can be measured as implicit put
options). This quantitative risk-oriented approach
has two important advantages. First, it is a potentially useful new tool with which to gauge the risk
reduction benets of holding liquid foreign currency reserves versus other nancial instruments
for managing risk. In many countries the buildup of reserves has been much larger than is justied
by short-term liquidity needs. Asian countries with
booming export sectors and commodity exporters
have amassed large reserve positions. Reserves in
excess of the required liquid reserves can be invested
in higher return but less-liquid instruments. The
framework described here can be used to assess
investment strategies that provide likely optimal
hedging, diversication/risk reduction tailored for
the specic risk characteristics of a country.25
Excess reserves should be invested in instruments
that improve the diversication of the sovereign
portfolio.
long
long
long
short put options
22
23
24
6 Conclusions
The high cost of international economic and nancial crises highlights the need for a comprehensive
framework to assess the robustness of countries
economic and nancial systems. This paper proposes a new approach to measure, analyze, and
manage sovereign risk based on the theory and
practice of modern CCA. We illustrate how to
use CCA to model and measure sovereign risk
exposures and analyze policies to offset their potentially harmful effects. The paper provides a new
framework for adapting the CCA model to the
sovereign balance sheet in a way that can help forecast credit spreads and evaluate credit and market
risks for the sovereign and risks transferred from
other sectors. This new framework is useful for
assessing vulnerability, policy analysis, sovereign
credit risk analysis, sovereign capital structure,
and design of sovereign risk mitigation and control strategies. Applications of this framework for
investors in three areas are discussed. First, CCA
provides a new for valuing, investing, and trading sovereign securities, including SCSA. Second,
it provides a new framework for sovereign asset
and wealth management which is particularly applicable to the increasingly large sovereign wealth
funds being created by many emerging market
and resource rich countries. Third, the framework
provides quantitative measures of sovereign risk
exposures which allow for potential new ways of
transferring sovereign risk. New instruments and
risk transfer contracting arrangements can be developed using ART tools applied to sovereign risk
management.
Assets
Liabilities
Foreign Reserves
Obligation to supply FX to
Government to pay FX Debt
Credit to Government
Base Money
GOVERNMENT PARTNER
Guarantees
(to too-important-to-fail
entities)
or private institutions or inate to cover potential shortfalls. Also, in some countries, banks may
have deposits with the monetary authorities that
receive a priority claim on foreign currency reserves
that is higher than that of holders of local currency, which could be junior to claims on foreign
currency for payment of external foreign-currency
debt.
The priority of the claims can vary from country to
country. In many cases, though, we can think of the
guarantees to banks or other too-important-to-fail
entities as senior claims. Also most governments
nd it easier to inate or dilute local-currency
debt in a distress situation before defaulting on
foreign-currency debt. Thus a case can be made that
foreign-currency debt is senior to local-currency
25
26
10
11
12
5
6
7
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
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31
32
References
Allen, M., Rosenberg, C., Keller, C., Sester, B., and Roubini,
N. (2002). A Balance Sheet Approach to Financial Crisis.
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