Country Default Probabilities: Assessing and Backtesting

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Country Default Probabilities: Assessing and Backtesting

by Stefan Huschens of the Technische Universität Dresden,
Alexander Karmann of the Technische Universität Dresden,
Dominik Maltritz of the Technische Universität Dresden, and
Konstantin Vogl of the Technische Universität Dresden

September 1, 2006

Abstract: We address the problem how to estimate default probabilities for sovereign countries based on market data of traded debt. A structural Merton-type model is applied to a sample of emerging market and transition countries. In this context, only few and heterogeneous default probabilities are derived, which is problematic for backtesting. To deal with this problem, we construct likelihood ratio test statistics and quick backtesting procedures.

JEL Classification: C12, C53, F34, G33.

Keywords: Sovereign default, Country risk, Default probability, Likelihood ratio test, Backtesting.

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