Journal of Credit Risk

Risk.net

Sovereign probabilities of default in the euro area

Rainer Jobst

  • Probability of default forecasts without distress risk premium from CDS spreads for EU sovereigns.
  • Probability of default forecasts as an upper bound for real-world probability of defaults.
  • Negative correlation between our and rating based approaches.
  • All rating-based approaches are not risk sensitive.

We decompose credit default swap spreads of euro area member states into their risk premium and default risk elements. Further, we forecast one-year probabilities of default. The derived values can be viewed as an upper bound for the real-world probabilities that account for the high estimation risk in low-default portfolios. We show that they are more suitable for risk assessment than probabilities of default from other methods that rely on external rating categories. The correlations between the regulatory capital requirements from our approach and from the other analyzed alternatives for probability of default estimation are negative during the 2008–18 sample period.

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