A Simple Sovereign Default Model

A very influential model in the determination of capital requirements for credit exposures is Vacisek’s model. This model underpins the Basel framework for credit exposures of financial institutions. Vacisek’s model uses information on asset correlation and the unconditional mean of the probability of default to derive the conditional probability of default under stress. However, the concept of asset values applies best to corporations rather than to sovereign exposures. We adapt Vacisek’s model to capture the event of a sovereign default that results from a country hitting certain thresholds of economic distress. A reasonable assumption is that a significant drop in foreign reserve assets triggers the default event in a developing country as observed during the 1980s debt crisis, in which highly indebted Latin American countries and other developing regions were unable to repay the debt.