Sovereign Credit Risk in a Hidden Markov Regime - Switching Framework. Part 2

This research applies a discrete-time Markov-modulated model to default probability estimation and adapts it to Merton’s contingent claims approach, backing the hypothesis that a regime-switching framework which allows for structural shifts can substantially improve the underestimation of default probabilities associated with the Merton structural model. The modeling apparatus is applied to sovereign risk proving that the methodology can be tractably extended to a contingent claims approach, and is investigated as a followup paper to an extensive methodology found in the previous edition of the Capco Journal of Financial Transformation (37) [Potgieter and Fusai (2013)]. CDS quotes are used to calibrate the regime switching model and are then used to estimate sovereign assets in both developed and emerging markets