P1.T4.916. Predicting sovereign default (Damodaran)

Nicole Seaman

Director of FRM Operations
Staff member
Learning objectives: Describe the consequences of sovereign default. Describe factors that influence the level of sovereign default risk; explain and assess how rating agencies measure sovereign default risks. Describe the advantages and disadvantages of using the sovereign default spread as a predictor of defaults


916.1. Rebecca is evaluating four different countries in an attempt to determine their respective default risk. She evaluates the countries in four categories: degree of indebtedness as measured by debt as a percentage of gross domestic product; social service/pension commitments as estimated by the average age of the population; nature of the economy (e.g., diverse versus concentrated in oil as a natural resource), and monetary policy. The four countries are summarized in the exhibit below:


Which of the four countries is most likely to default?

a. Country A is the most likely to default because debt above 100% is highly predictive of default and overwhelms the other indicators
b. Country B is the most likely to default because it is the only country with three (out of four) negative indicators
c. Country C is the most likely to default because it has an autocratic government
d. It is unclear: each has two negative (and two positive) indicators; further, quantification of this scorecard is an insufficient predictor

916.2. As of the twentieth century (i.e., beginning 1900 and afterward), each of the following is TRUE about the consequences of sovereign default EXCEPT which is false?

a. Renders banking system more fragile: the probability of a banking crisis increases in countries that have defaulted
b. Increased probability of military occupation: subsequent to default, the probability of a military show of force increases by 25.0%
c. Negative impact on economy: real GDP tends to drop between 0.5% and 2.0% albeit the decline is short-lived and mostly in the first year subsequent to default
d. Negative impact on trade: export industries tend to be particularly hurt by sovereign default; one study indicates a drop of 8.0% in bilateral trade subsequent to default

916.3. Damodaran explains that "If governments can default, we need measures of sovereign default risk not only to set interest rates on sovereign bonds and loans but to price all other assets." His discussion includes three approaches (or measures) to predicting sovereign defaults: agency ratings, market-based sovereign default spreads, and sovereign credit default swap (CDS) prices. Below is his table comparing selected agency ratings to default spreads:

About these three approaches to predicting sovereign defaults, which of the following is TRUE according to Damodaran?

a. Market-based default spreads have at least two advantages: they are more granular than agency ratings, and they are more time-dynamic
b. The global risk-free rate is best estimated as the lowest interest rate offered on a 10-year government bond among the OECD countries
c. Compared to sovereign market default spreads, sovereign credit default swap (CDS) prices are superior predictors of default because they are both faster and more accurate
d. Agency ratings are not useful because markets are already aware of the information agencies use to rate sovereign bonds such that market prices are a super-set of information

Answers here: