Implied Probability of Default and the European Sovereign Debt Crisis

Open Access
Author:
Aarons, Ross Hanson
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Louis Gattis Jr., Thesis Supervisor
  • James Alan Miles, Honors Advisor
  • Christoph Hinkelmann, Faculty Reader
Keywords:
  • Probability of Default
  • Europe
  • Debt Crisis
  • Reduced Form Model
  • Greece
  • Ireland
  • Portugal
  • Italy
  • Spain
  • France
  • Belgium
Abstract:
Although the integration of European nations to create the European Union is the result of years of progress, the establishment of the Eurozone, the group of nations using the euro as a single currency, is a fairly new event in European history. While many economies enjoyed relatively prosperous years in the early existence of the euro, the global financial crisis in late 2008 and subsequent sovereign debt crises in several member nations has the future of the Eurozone, and the continuing existence of the euro as a currency, in doubt. With investors concerned over several Eurozone nations’ levels of debt, the market for government securities remains volatile. In several cases, external funding from the European Central Bank and International Monetary Fund has been necessary to avoid default in the face of rising yields on government securities. Greece, Ireland, and Portugal have all received bailouts, and many believe that these are not the last countries to require funding. Italy, Spain, France, and Belgium all have high levels of debt, and the market clearly shows investors’ lack of confidence about their futures. This study applies a reduced form model to the debt of these countries to derive an implied probability of default for various durations of time, ranging from one to five years. The results show high probabilities of default for Greece, Portugal, Ireland, Italy, and Spain, although in most cases probabilities have decreased since late 2011.