Sovereign CDS Spreads with Credit Rating

Prof. Li Haitao

Cheung Kong Graduate School of Business (CKGSB)

About the Speaker

Prof. Li Haitao is the Dean’s Distinguished Chair Professor of Finance and Associate Dean for the MBA Program at CKGSB. Previously, he was the Jack D. Sparks Whirlpool Corporation Research Professor in the Finance Department of the Stephen M. Ross School of Business at the University of Michigan. He also served on the faculty of the Johnson Graduate School of Management at Cornell University. Prof. Li serves on the editorial boards of Management Science (the Department of Finance) and the International Review of Finance. Prof. Li holds a PhD in Finance from Yale University.

His research areas include theoretical and empirical asset pricing, continuous-time finance, term structure, credit risk, option pricing, financial econometrics and hedge funds.

About the Seminar

We study the nature of sovereign credit risk through a rating-based continuous-time model for sovereign CDS spreads. 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 we replace the observed ratings with the model implied ratings.