^*Michael Gapen is an economist with the IMF Institute; Dale Gray is a senior economist and Cheng Hoon Lim is a division chief with the IMF Monetary and Capital Markets Department; and Yingbin Xiao is an economist with the IMF European Department. The authors would like to thank Zvi Bodie, Carlos Medeiros, Robert Merton, Linda Tesar, and participants of the JPMorgan Chase seminars at the 2005 Annual Meetings of the Inter-American Development Bank in Okinawa and the Asian Development Bank in Istanbul, the Institute of International Finance Country Risk Workshop, and the IMF Institute for helpful comments and suggestions. We would also like to thank an anonymous referee for helpful suggestions.

Abstract

This paper develops a comprehensive new framework to measure and analyze sovereign risk. Contingent claims analysis is used to construct a marked-to-market balance sheet for the sovereign and derive a set of forward-looking credit risk indicators that serve as a barometer of sovereign risk. Applications to 12 emerging market economies show the approach to be robust, and the risk indicators are a significant improvement over traditional macroeconomic vulnerability indicators and accounting-based measures. The framework can help policymakers design risk mitigation strategies and rank policy options using a calibrated structural model unique to each economy.