Capco: Sovereign Credit Risk in a Hidden Markov Regime-Switching Framework

Standard approaches to estimating credit default probability estimation have certain drawbacks, most importantly regarding the underestimation of the true default probability which remains an undesirable property in sovereign risk management.

As an alternative, this research applies a discrete-time Markov-modulated model to default probability estimation and applies it to Merton’s contingent claims approach, offering an attractive combination of possibly resolving the underestimation