Assigning Eurozone sovereign credit ratings using CDS spreads

Purpose - The credit ratings issued by the Big 3 ratings agencies are inaccurate and slow to respond to market changes. This paper aims to develop a rigorous, transparent and robust credit assessment and rating scheme for sovereigns. Design/methodology/approach - This paper develops a regression-based model using credit default swap (CDS) data, and data on financial and macroeconomic variables to estimate sovereign CDS spreads. Using these spreads, the default probabilities of sovereigns can be estimated. The new ratings scheme is then used in conjunction with these default probabilities to assign credit ratings to sovereigns. Findings - The developed model accurately estimates CDS spreads (based on RMSE values). Credit ratings issued retrospectively using the new scheme reflect reality better. Research limitations/implications - This paper reveals that both macroeconomic and financial factors affect both systemic and idiosyncratic risks for sovereigns. Practical implications - The developed credit assessment and ratings scheme can be used to evaluate the creditworthiness of sovereigns and subsequently assign robust credit ratings. Social implications - The transparency and rigor of the new scheme will result in better and trustworthy indications of a sovereign’s financial health. Investors and monetary authorities can make better informed decisions. The episodes that occurred during the debt crisis could be avoided. Originality/value - This paper uses both financial and macroeconomic data to estimate CDS spreads and demonstrates that both financial and macroeconomic factors affect sovereign systemic and idiosyncratic risk. The proposed credit assessment and ratings schemes could supplement or potentially replace the credit ratings issued by the Big 3 ratings agencies.