Explaining how important credit rating is in practice for accessing a nation’s credit worthiness, Prof. Li detailed how rating agencies rank a nation by macroeconomic fundamentals and political risk. And it provides first-order approximation of a nation’s credit risk, he opined. He further explained that the early studies show that ratings explain cross-sectional sovereign credit risk well but do not consider dynamics of sovereign credit risk and no-arbitrage restrictions. In response to this, their paper studies a rating-based on no-arbitrage sovereign credit risk model.
Going further into what their research studies, Prof. Li said that rating transition follows a Markov chain, and countries with the same credit rating share the same level of systematic default risk. Empirical analysis shows that the explicit modeling of the dependence of sovereign credit risk on rating can enable the model to jointly capture the cross-sectional and time-series variations of sovereign CDS spreads of multiple countries. Consequently, a parsimonious version of the model can simultaneously capture the term structure of the CDS spreads of 34 in-sample and 34 out-of- sample countries well. The common factor, along with the observed ratings, can explain more than 60% of the variations of sovereign CDS spreads of all countries. This explanatory power jumps to more than 80% when they replace the observed ratings with the model implied ratings.
A PhD holder in Finance from Yale University, Prof. Li served on the faculty of the Johnson Graduate School of Management at Cornell University, and the editorial boards of Management Science (the Department of Finance) and the International Review of Finance. Prof. Li. His research areas include theoretical and empirical asset pricing, continuous-time finance, term structure, credit risk, option pricing, financial econometrics and hedge funds.
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