17 JUNE 2011

MODELING METHODOLOGY
Authors
Amnon Levy Nihil Patel Libor Pospisil Vojislav Sesum

Modeling Sovereign Correlations

Abstract
Sovereign exposures comprise a large part of financial institutions credit portfolios, and are often held due to their perceived low risk. While many sovereign exposures indeed exhibit low default probabilities when considered on a stand-alone basis, a proper risk assessment must also account for correlations. In this paper, we develop a sovereign correlation methodology which parameterizes the Moodys Analytics Global Correlation Model (GCorr) and uses sovereign CDS data to estimate parameters. With this methodology, we can determine correlations among sovereign exposures, as well as correlations between sovereign exposures and other asset classes within a credit portfolio. In addition, utilizing the GCorr factor structure allows us to capture the interdependencies among sovereigns due to their intertwined economies. Ultimately, our model allows risk managers to quantitatively assess the risk of sovereign exposures within a credit portfolio by taking into account both the stand-alone and the portfolio aspects of sovereign credit risk.

Contact Us
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Table of Contents
1 Introduction ........................................................................................................................................................... 5
1.1 Methodology Overview.........................................................................................................................................................................................5

2 3

Moodys Analytics Portfolio Modeling Framework ..............................................................................................6 Methodology ..........................................................................................................................................................9

3.1 Definition of Sovereign Custom Indexes..............................................................................................................................................................9 3.2 Estimation Method for Sovereign R-squared Values ..........................................................................................................................................9

Data ...................................................................................................................................................................... 10
4.1 Sovereign CDS Data............................................................................................................................................................................................. 11 4.2 Corporate CDS Data ............................................................................................................................................................................................13

Estimation of Sovereign R-squared Values and Results ..................................................................................... 13

5.1 R-squared Values for Sovereigns with CDS Data ..............................................................................................................................................14 5.2 Modeled Sovereign R-squared Values ................................................................................................................................................................14

Validation of the Sovereign Correlation Model .................................................................................................. 15

6.1 In-sample Validation: Cross-sectional Fit .......................................................................................................................................................... 15 6.2 Out-of-sample Validation: Correlations with Corporates................................................................................................................................ 16 6.3 Out-of-sample Validation: Estimating Sovereign R-squared Values Using Corporate CDS Spreads............................................................ 16

7 8

Portfolio Analysis ................................................................................................................................................. 17 Conclusion............................................................................................................................................................ 17

Appendix A .................................................................................................................................................................. 18 Appendix B ................................................................................................................................................................. 20 References ................................................................................................................................................................... 21

MODELING SOVEREIGN CORRELATIONS

1 Introduction
Financial institutions carry a large number of sovereign debt exposures within their credit portfolios. In order to adequately assess the risk posed by sovereign exposures in the portfolio context, the institutions need to first determine the exposures stand-alone risk, namely the probabilities of default. In addition, they must measure the exposures correlation effects on the portfolios. This entails modeling correlations among changes in sovereigns credit qualities and between changes in the credit qualities of sovereigns and other borrowers in the portfolio. Sovereign debt instruments are often included in a portfolio due purely to their perceived low stand-alone risk, while the level of correlation between sovereign and other instrument types is not accounted for because quantifying such correlations is challenging. Moodys Analytics has developed a model for sovereign correlations, which we introduce in this paper. In the model, we leverage the sovereign CDS market data to estimate spread-implied asset correlations and the Moodys Analytics GCorr modeling framework to capture the complex interdependency structure of sovereign nations economies. Utilizing the GCorr model has another advantage as it allows us to estimate the correlations of sovereign exposures with other instruments within a credit portfolio. The methodology for sovereign correlations provides risk managers with parameter estimates that match some of the significant empirical patterns found in sovereign spread-implied asset correlations. Specifically, we find that correlations between two sovereigns tend to be higher than correlations between corporates from the corresponding countries. This 1 finding is consistent with the academic literature on sovereign CDS spreads. There is also considerable variation in correlation levels across countries. Moreover, sovereigns within certain regions, such as Southern Europe or Eastern Europe, are highly correlated. Some of these patterns are related to the economic concept of sovereign credit contagion, wherein a sovereign credit crisis in one country triggers a similar crisis in neighboring countries.

1.1 Methodology Overview

This section provides a brief overview of the modeling methodology. We begin with liquid CDS spreads and convert the 2 spreads to distance-to-default (DD) measures based on the Kealhofer-Vasicek structural model of credit risk. In this model, the correlation between changes in DD is equivalent to asset correlation. We use the changes in DD, rather than the changes in spreads, to calculate correlations between the sovereigns. The reason is that the volatility of spread changes depends on the underlying entitys probability of default within the Kealhofer-Vasicek framework, while the volatility of DD change is constant over time. Having calculated the spread-implied asset correlations (i.e., correlation among the DD changes derived from spreads), we integrate sovereigns into the Moodys Analytics GCorr model by assigning each sovereign a custom indexa weighted combination of GCorr Corporate country and industry factors, which describe the sovereigns systematic risk. Subsequently, we determine the sovereign R-squared values defined as sensitivities of the sovereigns credit quality changes to the returns of the custom indexes. Within our methodology, the custom index incorporates information related not only to the sovereigns own country but also to other countries from the region where the sovereign is located. This model feature accounts for 3 interdependent economies and the concept of sovereign credit contagion. The definition of sovereign custom indexes together with the spread-implied sovereign asset correlations allows us to estimate sovereign GCorr R-squared values. A general interpretation of a sovereigns R-squared is that it represents the percentage of variation in a sovereigns credit quality explained by the variation in the sovereigns country and region fundamentals, where fundamentals are defined as corporate firm assets in that country and region.

See, for example, Longstaff et al. (2008), or other recent academic papers that analyze sovereign CDS spreads, such as Hilscher and Nosbusch (2010), Augustin and Todengap (2010), Pan and Singleton (2008), or Remolona et al. (2008). For details on the estimation of DD from CDS spreads, please refer to Appendix B.

2 3

An example of sovereign credit contagion is the 2010/2011 sovereign debt crisis in Greece, which is affecting other countries in Europe. Longstaff et al. (2008) provide another example of such contagion: [] Russian Default/LTCM crisis resulted in a major funding event in the hedge-fund industry that then translated into common liquidity-related contagion in sovereign credit spreads.

MODELING SOVEREIGN CORRELATIONS

After applying the estimation methodology to the CDS data, we find that the R-squared values for different sovereigns are spread out over a wide range of values, indicating that sovereigns vary in the extent to which changes in their corporate fundamentals translate to changes in their default risk. Therefore, using the same R-squared to calculate correlations leads to overestimating the correlations for some sovereign pairs, while underestimating it for others. Finally, we validate our results by conducting three tests. In the first validation exercise, we compare the cross-sectional fit of the modeled sovereign pair-wise asset correlations with the empirical spread-implied asset correlations. In the second validation exercise, which can be viewed as an out-of-sample test, we use the spread-implied correlations between sovereigns and corporates. We show that sovereigns that are highly correlated with other sovereigns tend to be highly correlated with corporates as well, indicating that sovereign and corporate credit is driven by a similar set of factors, as our model assumes. In the third test, we use both corporate and sovereign spread-implied asset correlations to compute sovereign R-squared values as an alternative model specification. The estimation results of this alternative specification broadly match our original R-squared values. The remainder of this paper is organized in the following way.

Section 2 describes the Moodys Analytics Portfolio Analytics framework. Section 3 outlines the Moodys Analytics methodology for estimating sovereign correlations. Section 4 describes the sovereign and corporate credit data used in the estimation and validation. Section 5 presents the estimation details and resulting GCorr R-squared estimates. Section 6 describes the different validation exercises conducted. Section 7 outlines our sovereign correlation parameters effect on portfolio risk measures. Section 8 concludes the paper. Appendix A provides information about the 89 sovereigns considered in this paper. Appendix B details the use of CDS spread term structure to back out the distance-to-default measure.

2 Moodys Analytics Portfolio Modeling Framework

There are two basic types of credit correlations: default correlations and credit migration correlations. Default correlation measures the extent to which the default of one borrower is related to that of another borrower. Credit migration correlation measures the joint credit quality change, short of default, for two borrowers. We can infer the credit correlations of two borrowers by measuring their individual default probabilities and their asset correlation. The basic idea is intuitive: a borrower defaults when its asset value falls below the value of its obligations (i.e., its default point). The joint probability of two borrowers defaulting during the same time period is simply the likelihood of both borrowers asset values falling below their respective default points during that period. We can determine this probability by knowing the correlation between the two borrowers asset values, and the individual likelihood of each borrower defaulting, as depicted in Figure 1.
k defaults, j pays Borrower j Firm Y Both pay

k pays, j defaults

Both default Borrower Firm X k

Figure 1

Joint default

With this setup, the joint distribution of the borrowers asset values can be specified by the marginal distributions and a copula. Alternatively, the asset values dynamics can be captured by a factor model. For example:
ri = i i + 1 i i
(1)

Where ri is the asset return of borrower i, i is the systematic factor, i is the R-squared of borrower ithe proportion of risk that is captured by the systematic factor, i is the idiosyncratic factor of borrower i. The systematic factor i (also called custom index) represents the state of economy during a particular period, and summarizes all the relevant systematic risk factors that affect the borrowers credit quality. The variable i represents the borrower-specific risk (the idiosyncratic event or shock) that affects the borrowers credit quality or ability to repay its debt. While the shock in the systematic factor i is the same for borrowers with the same custom index, the borrower-specific shock i is unique to each borrower. In the model, the systematic factor i is independent of the idiosyncratic factor i. and both have a standard normal distribution. Two borrowers correlate with one another when both are exposed to correlated systematic factors (with potentially varying degrees). Mathematically, the correlation between the changes in 4 credit quality measure of any two borrowers, both within and across asset classes, is equal to:
corr (ri , rj ) = corr ( i i + 1 i i , j j + 1 j j ) = = cov( i i + 1 i i , j j + 1 j j )

rr
i

(2)
j

i j cov(i , j ) = 1*1

i j corr (i , j )

If the underlying borrowers are part of the same market and thus share the same systematic factor, the correlation is equal to the product of the square root of the two borrowers R-squared values:
corr (ri , rj ) = corr ( i + 1 i i , j + 1 j j ) =
i j cov( , )

1*1

= i j

(3)

Equation (1) serves as the basis for the Monte Carlo simulation, which is used to calculate portfolio credit risk. A factor model such as equation (1) can be specified by two sets of parameters: the R-squared values of all borrowers and the 5 correlations among systematic factors.

The RiskFrontier Monte Carlo simulation engine simulates correlated asset returns for each borrower i, in a normalized space where each asset return is distributed with a standard normal distribution. See Modeling Credit Portfolios for more details. See Modeling Credit Portfolios for details about how the RiskFrontier Monte Carlo engine simulates correlated asset returns for various asset classes.
5

MODELING SOVEREIGN CORRELATIONS

Moodys Analytics version of equation (1), known as GCorr, is graphically represented in Figure 2.

Figure 2

Structure of the Moodys Analytics Global Correlation Model (GCorr)

For a sovereign borrower, the set of systematic factors contains 49 country factors and 61 industry factors, as shown in Figure 3.

Sovereign Nation Systematic Risk Sovereign Specific Risk 61 Industry Factors

49 Country Factors

Figure 3

Decomposing a sovereign borrowers credit risk

3 Methodology
The asset return correlation between two borrowers in the GCorr framework is given by equation (2). In order to integrate sovereigns into GCorr, we need to specify their custom indexes and develop a method to estimate their Rsquared values.

3.1 Definition of Sovereign Custom Indexes

We construct the sovereign js custom index by using a weighted combination of the GCorr country and industry factors. Specifically, the custom index for a sovereign j will be:

= j
Where weights

= 1= 1 i k

wi

61

Sov j

ri Industry + wk j rkCountry
Sov

49

(4)

ri Industry {i =1 to 61} are the GCorr industry factors and rkCountry {k =1 to 49} are the GCorr country factors. The

wi

Sov j

{i =1 to 61} are the sovereign js industry weights and they are determined based on the GDP composition
6

of the region to which the sovereign belongs. The weights wk j {k =1 to 49} are sovereign js country weights. These weights are determined by GDP weighting countries from the sovereigns region, with an extra weight put on the sovereigns own country factor. We determined the amount of overweighting the sovereigns own country factor by optimizing the fit between predicted and empirical sovereign asset correlations across our sample. We decided to construct the sovereign custom index using information from the sovereigns region as well as from the sovereign itself. This decision was motivated by our aim to take into account interdependencies of economies and the possible sovereign contagion effect, wherein a debt crisis in one country is related to a debt crisis in countries in the same regional and economic group.

Sov

3.2 Estimation Method for Sovereign R-squared Values

The R-squared of a firm in the GCorr model is estimated using its asset returns, which are based on balance sheet information, risk-free interest rates and equity returns. However, the same method cannot be applied to sovereigns. To address this challenge, our methodology for estimating sovereign R-squared values relies on the correlations inferred from the sovereign CDS market. To estimate sovereign R-squared values, we first calculate the pair-wise asset correlations among sovereigns. For this purpose, we back out the probability of default from the term structure of sovereign CDS spreads using the KealhoferVasicek model, using the same approach for calculating the spread-implied EDF as outlined in Dwyer et al. (2010). These probabilities of default can be readily converted to the distance-to-default (DD) measures as shown in Appendix B. Having calculated the weekly time series of DD for each sovereign, we calculate the correlation between DD changes for each pair of sovereigns: , . We choose to calculate the correlations between sovereigns using DD changes rather than raw spreads because changes in spreads are non-stationary in the Kealhofer-Vasicek model, unlike changes in DD. More precisely, the volatility of the spread changes tends to be low when the default probability of the underlying obligor is low, and vice versa.

The data on GDP levels and GDP composition were obtained from International Monetary Fund (www.imf.org) and CIA The World Factbook (www.cia.gov).

MODELING SOVEREIGN CORRELATIONS

In the final step of the sovereign R-squared estimation, we estimate the following regression model, motivated by equation (2), on the set of all pairs of sovereigns:
CDS , DDCDS corr DD k , SOV l , SOV log corr (k , l ) log( RSQ ) + log( RSQ ) + = 1 + 1 + . = k l k k l l i i
(5)

In equation (5), 1k is an indicator variable, and k , defined as log( RSQk ) , are the coefficients of the regression. The 2 estimates of k can be converted to estimates of R-squared values using the transformation RSQk = e k . We apply the OLS method to the regression model in equation (5) to estimate the R-squared values for 64 countries with liquid sovereign CDS spreads. We then use these results to model R-squared values for the remaining 25 countries in our study. The details of that interpolation are given in Section 5.2. Recall that a sovereigns R-squared measures the percentage of variation in sovereign credit risk changes explained by the changes in the sovereigns fundamentals, where we define fundamentals as the assets of the corporate firms in that country and region.

4 Data
In this section, we discuss data-related issues that arise when modeling sovereign correlations. Furthermore, we describe the specific CDS datasets we used to estimate and validate the Moodys Analytics sovereign correlation model. Theoretically, there are four basic data sources to consider when estimating sovereign correlations: default rates, credit ratings, sovereign bond data, and CDS data. Moodys Analytics uses time series of historical default rates to estimate correlation models for CRE, retail, and other asset classes with no available market data. However, given the small number of sovereign defaults over past decades, this approach is not feasible. Credit ratings provide credit rating agency views of sovereign credit qualities. By design, ratings represent a long-term, or through-the-cycle, assessment of credit risk. As a result, ratings do not change frequently enough to be used in a model of sovereign credit quality co-movements. Market sovereign bond yields and sovereign CDS spreads can be used to obtain a dynamic market view of sovereign credit risk. This feature makes this type of data most suitable for estimating a sovereign correlation model. Despite issues with sovereign CDS spreads, we decided to use them as our data source because the disadvantages of sovereign bond yields are larger. Namely, transforming market bond yields into credit quality measures involves several challenges, which we can avoid by using CDS spreads. This removes the risk-free component of the yield and accounts for possible embedded optionalities (e.g., early exercise) and other bond features. Another important issue affecting both sovereign CDS and sovereign bonds is liquidity. To conclude, we use market CDS datasets to estimate and validate the sovereign correlation model. In Sections 4.1 and 4.2, we describe the datasets and discuss how we addressed related issues, such as liquidity.

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4.1 Sovereign CDS Data

We estimated the sovereign correlation model, introduced in Section 3, using sovereign CDS data. To validate the model, we utilized corporate CDS data, described in Section 4.2. For our model, the data vendor Markit provided both sovereign and corporate CDS spreads. Moodys Analytics employs the same datasets for estimation of CDS-implied EDF 7 credit measures. There are two aspects of the CDS datasets worth discussing in more detail.

CDS spreads are functions of currency, doc clause, tier, and tenor. For each reference entity, we aggregate these spreads across currencies, doc clauses, and tiers to obtain a single spread term structure at a given point in time. Raw spreads given to Markit by dealers differ by currency, but the differences are generally not systematic. Aggregating across currencies provides fuller coverage and is more robust. Aggregating across doc clauses also leads to fuller coverage and more model stability. Since spreads differ systematically by doc clause, we convert each spread into a common doc clause. Another approach is to use the most liquid doc clauses. However, such doc clauses typically depend on the region and rating of the reference entity. Moreover, doc clause conventions can and do change over time, and spreads of different doc clauses are on a less even footing with each other. Therefore, aggregating spreads across doc clauses enables us to limit any disadvantages and discrepancies. The CDS spreads from Markit are quotes from contributing CDS dealers, and therefore do not represent actual transactions. Despite this fact, we decided to use the Markit data because they provide a wider coverage than transaction data. To avoid CDS spread quotes that are less likely to reflect sovereign credit risk, we applied several liquidity filters to the data. These filters can remove stale quotes or focus on time periods with the largest changes in credit quality.

We restrict the time range of sovereign CDS spreads for the model estimation to period July 2008June 2010. We selected the beginning of this period to remove pre-crisis spreads from the estimation. This is because we want to focus mainly on the credit risk component of the CDS spreads, which had a smaller impact on high quality sovereign spreads before the financial crisis than during the crisis. As shown in Figure 4, we see that 5-year cumulative spread-implied EDF credit measures for six select countries began to increase dramatically from July 2008 onward. 13.00% 11.00% 9.00% 7.00% 5.00% 3.00% 1.00% -1.00% 2007 Figure 4 2008 2009 2010 France Italy Japan Greece Portugal China

The 5-year cumulative spread-implied EDF credit measures for select countries, January 2007July 2010

For more information about this data, see Dwyer et al. (2010).

MODELING SOVEREIGN CORRELATIONS

11

It is worth pointing out that the spreads and 5-year cumulative spread-implied EDF credit measures for most countries have been moving in tandem even prior to July 2008, as shown in Figure 5.

12.50% 6.25% 3.13% 1.56% 0.78% 0.39% 0.20% 0.10% 0.05% 0.02% 0.01% 0.01% 0.00% 2007 Figure 5 2008 2009 2010

France Italy Japan Greece Portugal China

The 5-year cumulative spread-implied EDF credit measures for select countries: January 2007July 2010, log-scale

Overall, CDS spreads of varying quality are available for 89 sovereigns. To address the liquidity issue and create a dataset suitable for estimation, we consider only sovereigns with at least 80 weekly reliable spreads over the period July 2008-June 2010 (i.e., spreads that are neither missing nor stale). Spread time series of 64 sovereigns meet this condition. We then convert the weekly CDS spreads for the 64 sovereigns over the period July 2008June 2010 to distance-todefault (DD) according to the methodology discussed in Appendix B. Subsequently, we determine weekly DD, or measures of the sovereigns credit quality changes. To further reduce the effect of liquidity in the data, we apply another filter. Namely, we select only 50% of weeks from the period (56 weeks), during which changes in DD for USA were largest. The rationale for this filter is based on the fact that USA is one of the most creditworthy sovereigns (i.e., with low EDF) and therefore larger changes in its DD are more likely to be due to systematic credit risk. As a result, we can expect the liquidity component of DD changes to play a comparatively smaller role, and the credit risk component a bigger role during the selected weeks than during the remaining weeks. The transformation and filters lead to the following final sovereign sample: weekly DD changes for 64 sovereigns and 56 weeks with the strongest credit risk effect over the period July 2008June 2010. This final dataset is used for R-squared estimation, using the method described in Section 5.1. In addition, we are able to utilize the estimation results to calibrate R-squared values for the other 25 sovereigns for which reliable CDS spreads are not available, as described in Section 5.2. Overall, R-squared values are provided for 89 (= 64 + 25) sovereigns, representing of 99.5% of all 8 outstanding debt as of 2010. Table 1 in Appendix A lists the 89 sovereigns considered in this paper, including the indication whether adequate CDS spreads were available.

Source: Moodys Statistical HandbookCountry Credit, November 2010, Moodys Investors Service.

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4.2 Corporate CDS Data

While we primarily use sovereign CDS data to estimate sovereign R-squared values, we rely on corporate CDS data in our validation exercises. To construct our sample of corporate CDS data, we start with the time series of weekly CDS spreads of 2,618 North American and European firms. We apply several restrictions to this data. First, we exclude firms 9 not covered in GCorr, which reduces the number of firms to 2,107. Then, we consider only the names that were the most liquid through the sample period, and we exclude firms that have less than 80 reliable weekly CDS quotes over the period June 2008July 2010. These restrictions leave us with 364 firms as our final corporate sample, which we use in the validation exercises. The final corporate sample is approximately evenly divided between North American and European firms. The firms in this sample are, on average, larger and safer than the firms in the original corporate sample. Furthermore, firms with available CDS spreads are much larger than median GCorr firms.

5 Estimation of Sovereign R-squared Values and Results

In this section, we present the estimation details and the resulting sovereign R-squared values. We apply the methodology outlined in Section 3 to estimate R-squared values for the 64 sovereigns with sufficient CDS data. Section 4.1 describes how the dataset was created. Section 5.1 summarizes the details of this estimation. In Section 5.2, we discuss how we use the estimates to calibrate R-squared values using a comparables based approach for other 25 sovereigns without adequate CDS spreads. In Figure 6, we plotted histograms of the R-squared values for the 89 sovereigns and all pair-wise modeled sovereign correlations, defined by formula ( , ) = ( , ).

Let us highlight two main features of the R-squared values and modeled correlations. First, their median levels at 69% and 51%, respectively, are much higher than the corresponding values for corporates based on the GCorr 2010 Corporate model. Second, sovereign R-squared values are dispersed over a wide range, roughly 40% to 90%, and modeled sovereign correlations over a range of 20% to 90%. This highlights the peril of using just one correlation (or R-squared) for sovereignsit leads to overestimating correlations for some sovereign pairs, while underestimating correlations for others.

Figure 6

Histograms: R-squared values for 89 sovereigns and for modeled sovereign correlations.

We ensure that the corporate firms have GCorr correlation parameters so that we can calculate the custom index correlations and use the GCorr R-squared.

MODELING SOVEREIGN CORRELATIONS

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5.1 R-squared Values for Sovereigns with CDS Data

The methodology introduced in Section 3.2 applies only to sovereigns with sufficient CDS data. Therefore, we first select the 64 sovereigns that passed the data and liquidity filters described in Section 4.1. For these sovereigns, we determine the two sets of inputs of the estimation methodology: all pair-wise custom index correlations ( , ), and all pair-wise correlations of DD changes, ( , ). We use the GCorr 2010 Corporate factor covariance matrix to calculate the pair-wise correlations among the sovereigns custom indexes. The correlations of DD changes are calculated as empirical correlations of the time series of weekly DD changes over the 56 weeks during the period July 2008June 2010, where the weeks were selected to reduce the impact of liquidity issues on the results. Dwyer et al. (2010) and Appendix B contain details on deriving DD measures from CDS spreads.

Having calculated ( , ) and ( , ) for each pair of the 64 sovereigns (2,016 unique pair-wise correlations), we are able to estimate the regression model defined in equation (5) with the OLS method. We carry out the estimation in two stages. In stage 1, we use a sample of only the 20 safest sovereigns and estimate their parameters. In stage 2, the input data for the model is based on all 64 sovereigns, but we set the parameters for the 20 safest sovereigns equal to the values from stage 1. Subsequently, we can estimate parameters for the remaining 44 sovereigns. Finally, we convert the estimated parameters into 64 sovereign R-squared values. The advantage of the two stage estimation is that the average levels of empirical and fitted correlations match for both the sample of the 20 safest sovereigns and the entire sample of 64 sovereigns. Moreover, if we did not use the two stage procedure and estimated all parameters in one step, the R-squared values for the safest sovereigns would be artificially low because they have lower empirical correlations than riskier sovereigns due to the smaller importance of the credit risk component in their spreads. Such an outcome might lead to mismatch between empirical and modeled correlations of important sovereigns, such as USA and Germany. The two stage method enables us to avoid these issues.

5.2 Modeled Sovereign R-squared Values

The sovereign R-squared values estimated using the regression model specified in equation (5) exhibit certain patterns. First, similar countries have similar R-squared values. An example of this is countries in the same region that have broadly similar size and industry structure. Next, there is an association between the R-squared of a sovereign on one side, and its creditworthiness and size on the other side. We measure creditworthiness by spread-implied EDF, and size by Gross Domestic Product (GDP) in USD. These observations motivate our approach for using the estimated 64 sovereign R-squared values from Section 5.1 to calibrate R-squared values for 25 sovereigns without sufficient CDS data. In particular, we estimate the following relationship based on the 64 R-squared values:
= , , + (6)

As the input variables, we use the 5-year spread-implied EDF in June 2010, and GDP over the year 2010. After estimating model (6), we define comparables-based R-squared values for the 25 sovereigns as follows:
= , , + (0.75), = 1, ,25. (7)

In order to reduce effects of extreme R-squared values on the modeled correlations, we replace 10% of the highest and lowest values of the 89 sovereign R-squared values (the 64 R-squared values estimated directly from data and 25 R-squared values determined through a comparables based approach) with the 90th and 10th percentiles of the distribution, respectively.

The term (0.75) represents the empirical 75th percentile of the residuals from regression (5). Including this term in the equation results in more conservative comparables-based R-squared values.

Figure 7 displays the 5 year spread-implied EDF versus the 64 sovereign R-squared values estimated directly from CDS data and versus the 25 comparables based R-squared values, described in Section 5.2.

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As shown in Figure 7, the comparables-based R-squared values are dispersed among the R-squared values estimated directly from the CDS data. In addition, the comparables based R-squared values do not appear to be biased in any particular direction.

Figure 7

The association of spread-implied EDFs vs. estimated R-squared values

To conclude, the output of the methodologies presented in Sections 5.1 and 5.2 is a list of R-squared values for 89 sovereigns, which can be used together with the sovereign custom indexes defined in Section 3.1 to compute asset correlations according to formula (2).

6 Validation of the Sovereign Correlation Model

To validate the sovereign correlation methodology introduced in this paper, we perform the following three exercises.

In-sample validation assessing the cross-sectional fit between correlations implied by the model and empirical correlations. Out-of-sample validation based on correlations between sovereigns and corporates. Out-of-sample validation comparing the R-squared values from Section 5.1 with results of an alternative estimation method which includes information from corporate CDS spreads.

6.1 In-sample Validation: Cross-sectional Fit

As an in-sample validation exercise, we compare the modeled correlations to the empirical correlations across all pairs of the 64 sovereigns with adequate CDS spreads. For detailed information about this sample, see Section 4.1. For a given pair of sovereigns k and l, the modeled correlation ( ( , )) is defined using the R-squared values from Section 5.1 and the correlation of the sovereigns custom indexes. The empirical correlation ( ( , )) is calculated in the same way as in Section 5.1.

Given the regression equation (5) and the R-squared estimation method of Section 5.1, the average levels of modeled and empirical correlations are close at 52.3% and 51.9%, respectively. The slight difference in the average correlation levels can be attributed to the fact that we adjust the extreme estimated R-squared values, as described in Section 5.2. Overall, the differences between empirical and modeled correlations are not substantially biased in one direction.

The rank correlation between empirical and modeled correlations across the pairs of 64 sovereigns is 75.1%. Thus, the modeled correlations preserve not only the average level of empirical correlations, but also the ranking of the sovereign pairs by empirical correlations.

MODELING SOVEREIGN CORRELATIONS

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6.2 Out-of-sample Validation: Correlations with Corporates

In this exercise, our objective is to validate the main feature of our methodology using factors from the GCorr Corporate model to explain co-movements in sovereign credit quality. We use the corporate CDS data described in Section 4.2 to perform the following out-of-sample analysis. For each of the 64 sovereigns with adequate CDS data, we calculate the average empirical correlation across all pairs consisting of this 1 sovereign k and another sovereign: , , , . =1 We then convert the corporate CDS spreads to DD changes and for each sovereign k, we calculate its average empirical 1 , , , . correlation with corporates: =1 Finally, we determine the correlation of these averages across all 64 sovereigns k: 1
=1

, , , ,

Our methodology assumes that sovereign credit quality is affected by systematic factors similar to those of corporates. If this assumption is valid, we expect sovereigns that are, on average, highly correlated with other sovereigns (i.e., sovereigns with large loadings to the systemic factors) to be, on average, highly correlated with corporates as well because they share the systematic factors. In other words, the correlation in formula (8) should be high. The value of the correlation in formula (8) is high at 84%. This result suggests that the corporate and sovereign asset returns load on the same, or highly correlated, systematic factors, which is in line with our methodology assumption.

=1

, , ,

(8)

6.3 Out-of-sample Validation: Estimating Sovereign R-squared Values Using Corporate CDS Spreads
To assess the robustness of our results, we employ an alternative methodology to estimate sovereign R-squared values. Rather than rely on the empirical correlations among changes in sovereigns distance-to-default (DD) measures in equation (5), we estimate the R-squared values using the empirical correlations between changes in sovereign and corporate DD measures. Since correlations with corporates were not included in the original estimation, this approach can be considered an out-of-sample exercise. In particular, we estimate the following regression model: , DD corr DD k , SOV l , CORP log = log( RSQk ) + log( RSQl ) + i corr( k ,l ) We estimate this model on the sample consisting of the following.

(9)

The 20 safest sovereigns used in stage 1 of the method described in Section 5.1 364 corporates with adequate CDS data, described in Section 4.2

This procedure yields a new set of R-squared values for the 20 safest sovereigns. The median level of our original stage 1 R-squared estimates was 59.6%, while the median of the new set is 61.2%. The rank correlation between the original and new R-squared estimates, across the 20 sovereigns, is 79%. Thus, the median level and the ranking of the new Rsquared estimates and the original estimates are similar. In other words, using correlations between sovereigns and corporates for estimation does not fundamentally change sovereign R-squared values.

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7 Portfolio Analysis
Using a sovereign correlation model may significantly impact portfolio risk measures, such as unexpected loss or economic capital. Portfolio risk can be assessed adequately only if the model accounts for the special features of sovereign correlations, such as a generally high level of sovereign correlations, a large variation in correlations across pairs of sovereigns, and the tendency of sovereigns in the same geographical or economic group to be highly correlated. A simple approach assigning a single asset correlation value to all pairs of sovereigns should be considered with caution. As shown in Figure 6, sovereign R-squared values are dispersed over a wide range, roughly 40%90%, and modeled sovereign correlations are dispersed over a range of 20%90%. Thus, using only one correlation level for sovereigns leads to overestimating correlations for some sovereign pairs, while underestimating correlations for others. In addition, using Moodys Analytics sovereign correlation parameters rather than a very coarse model allows risk managers to properly account for sovereign risk concentration within a credit portfolio.

8 Conclusion
To determine the impact of sovereign credit exposures on a portfolio, an investor needs estimates of the correlations among various sovereign exposures, as well as the correlations of sovereign exposures with other asset classes in the portfolio. This paper develops and implements a methodology for estimating these correlations by utilizing the sovereign and corporate CDS market data and the Moodys Analytics GCorr factor model. Specifically, we define spread-implied asset correlations for sovereigns as correlations among changes in distance-todefault measures derived from CDS spreads. Subsequently, we integrate sovereigns into the Moodys Analytics GCorr model by assigning each sovereign a custom index. This index is a weighted combination of GCorr Corporate country and industry factors that describes the sovereigns systematic risk. The last step of the methodology is the R-squared estimation, which ensures that the average levels of modeled correlations and empirical correlations match. In this paper, we discuss the following empirical findings.

Correlations between two sovereigns tend to be higher than the correlations between two firms from the corresponding countries. There is considerable variation in correlation levels across countries, suggesting that using one fixed correlation level for all sovereigns is not prudent. Sovereigns within geographical or economic groups tend be highly correlated.

The correlation estimates presented in this paper cover 89 sovereign nations, accounting for over 99.5% of all outstanding sovereign debt. The modeling framework can be used to calculate the correlations not only among sovereigns, but also between sovereigns and other asset classes within a financial institutions credit portfolio. As a result, Moodys Analytics sovereign spread-implied EDF and sovereign correlation models allow risk managers to quantitatively assess the risk of sovereign exposures within a credit portfolio by accounting for both the stand-alone and portfolio aspects of risk.

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Appendix A
This appendix provides information about the 89 sovereigns considered in this paper, including whether adequate CDS spreads were available. Table 1 List of sovereigns and territories
CDS Data No No Yes Yes Yes Yes No Yes No Yes Yes Yes Yes Yes Yes Yes Yes No Yes Yes No No Yes Yes Yes No Yes Yes Yes Yes Yes Sovereign/Territory GHANA GREECE GUATEMALA HONG KONG HUNGARY ICELAND INDIA INDONESIA IRAQ IRELAND ISRAEL ITALY JAMAICA JAPAN JORDAN KAZAKHSTAN LATVIA LEBANESE REPUBLIC LITHUANIA MALAYSIA MALTA MEXICO MOROCCO NETHERLANDS NEW ZEALAND NIGERIA NORWAY OMAN PAKISTAN SRI LANKA SWEDEN CDS Data No Yes Yes Yes Yes No No Yes No Yes Yes Yes Yes Yes No Yes Yes Yes Yes Yes No Yes No Yes Yes No Yes No Yes No Yes

Sovereign/Territory ABU DHABI ANGOLA ARGENTINA AUSTRALIA AUSTRIA BAHRAIN BARBADOS BELGIUM BELIZE BRAZIL BULGARIA CANADA CHILE CHINA COLOMBIA COSTA RICA CROATIA CYPRUS CZECH REPUBLIC DENMARK DOMINICAN REPUBLIC ECUADOR EGYPT EL SALVADOR ESTONIA FIJI ISLANDS FINLAND FRANCE GERMANY PANAMA PERU

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Sovereign/Territory PHILIPPINES POLAND PORTUGAL QATAR ROMANIA RUSSIA SAUDI ARABIA SERBIA SINGAPORE SLOVAKIA SLOVENIA SOUTH AFRICA SOUTH KOREA SPAIN

CDS Data Yes Yes Yes Yes Yes Yes Yes No No Yes Yes Yes Yes Yes

Sovereign/Territory SWISS CONFEDERATION TAIWAN THAILAND TRINIDAD AND TOBAGO TUNISIA TURKEY UKRAINE UNITED ARAB EMIRATES UNITED KINGDOM URUGUAY USA VENEZUELA VIETNAM

CDS Data No No Yes No No Yes Yes No Yes Yes Yes Yes Yes

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Appendix B
This appendix details the use of CDS spread term structure to back out the distance-to-default measure. The approach taken in this paper mirrors the approach described in Dwyer et al. (2010). Estimating Distance-to-default from the CDS spreads We start by using the term structure of CDS spreads to determine the term structure of risk-neutral probabilities of default. We assume that the risk-neutral survival function is Weibull, which allows us to express the spreads in the following form: () = (, 0 , 1 ; ), where () represents the spread on the t-year CDS contract, LGD is the expected loss given default, is the default free discount curve, and 0 and 1 are Weibull parameters characterizing the risk-neutral default probability term structure. Subsequently, the t-year risk-neutral probability of default is We use the term structure of CDS spreads to estimate 0 and 1 for each issuer, enabling us to compute the risk-neutral probability of default using the formula above. In our estimation, we follow the industry convention and assume loss given default of 60% for corporates and 75% for sovereigns. The Black-Scholes-Merton framework assumes the following relation between the risk-neutral and the physical probabilities of default: () = 1 () + , () = 1 exp((0 )1 ).

where is the market Sharpe ratio, and is the correlation of the issuer with the market. We use this formula to convert () to (). In the last step, we transform the physical probability to distance-to-default measures for each entity (corporate and sovereign).

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References
Acknowledgements
We would like to thank Heather Russell and Jing Zhang for their valuable feedback.
Copyright 2011 Moody's Analytics, Inc. and/or its licensors and affiliates. All rights reserved.

References
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