| Summary: | This thesis is an analysis of sovereign default using option pricing models. The first part of the thesis applies the structural credit risk models of Gapen, Gray, Lim and Xiao, (GGLX) and Karmann and Maltritz (KM) to 25 countries accounting for about 75% of global GDP. The GGLX model underestimates sovereign spread and hence the probability of default. This confirms one of the main criticisms of structural credit risk models when applied to corporate default. By contrast, the estimates produced by the KM are far too high; the estimated probability of default is almost one in some cases. The second part of the thesis estimates the default risk indicators using the GGLX model in conjunction a number of different assumptions about the value of sovereign assets. It also uses market values of sovereign spread, which thus becomes an input to the model rather than an output. These approaches have not been reported in the literature before. In addition, Ito's lemma is used derive the corresponding geometric Brownian motion for sovereign spread. Using the new approach, the implied probabilities of default are larger than those obtained using standard GGLX. The model also gives revised values for domestic currency liability and its volatility. These are larger than the values reported by national agencies, thus contributing to the explanation of why structural credit risk models underestimate real-world credit spreads and the risk of default. The outputs from the model also lead to the construction of balance sheet ratios, which contribute to information about the likelihood of sovereign default. Overall, the new model results in default rankings and associated measures which are significantly more realistic than those produced by the standard GGLX model.
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