Journal Article | Journal of Investment Management | Fourth Quarter 2007

Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk

by Dale . F. Gray, Robert C. Merton and Zvi Bodie


This paper proposes a new approach to measure, analyze, and manage sovereign risk based on the theory and practice of modern contingent claims analysis (CCA). The paper provides a new framework for adapting the CCA model to the sovereign balance sheet in a way that can help forecast credit spreads and evaluate the impact of market risks and risks transferred from other sectors. This new framework is useful for assessing vulnerability, policy analysis, sovereign credit risk analysis, and design of sovereign risk mitigation and control strategies. Applications for investors in three areas are discussed. First, CCA provides a new framework for valuing, investing, and trading sovereign securities, including sovereign capital structure arbitrage. Second, it provides a new framework for analysis and management of sovereign wealth funds being created by many emerging market and resource rich countries. Third, the framework provides quantitative measures of sovereign risk exposures which facilitates the design of new instruments and contracts to control or transfer sovereign risk.

Keywords: Credit; Investment; Sovereign Finance; Risk Management; Emerging Markets; Market Transactions; Mathematical Methods; Valuation;


Gray, Dale . F., Robert C. Merton, and Zvi Bodie. "Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk." Special Issue on Credit Analysis Journal of Investment Management 5, no. 4 (Fourth Quarter 2007): 5–28.