Charles Gorintin, Don Goonetilleke, Yang Guo, Xin Heng, Michael Pensky, Ji Tan
Haas School of Business, University of California Berkeley
Master of Financial Engineering Program

Abstract

The current European debt crisis has made sovereign credit risk a popular topic. In this paper we adapt an established structural model for assessing sovereign credit risk and expand it to evaluate the cases of California and Greece. Specifically, major political events such as a bailout or a breakout from a monetary union are not accounted for in current models despite that they may introduce non-linearities in the behavior of the default probability. In this paper, we attempt to account for these extra factors and solve the problem numerically. We rely on a 2-D finite differences method, modeling both the risky assets of our target sovereignty and the ones of its encompassing monetary union. Finally, we detail a method for hedging sovereign credit risk using tradable securities.

This paper won the 2011 IAFE Academic Competition which you can read about here.