Sovereign Credit Rating

Definition

Sovereign Credit Rating is a Credit Rating metric of the Credit Risk associated with the liabilities of Sovereign entities, thus a measure of Sovereign Risk

Types

There are two major types of sovereign credit ratings

• Local Currency Rating
• Foreign Currency Rating

Methodologies

Credit Rating methodologies for Sovereigns span a range of approaches with the exception of purely statistical approaches (due to lack of significant historical data). Two major categories are the following:

• Expert based scorecards building on extensive fundamental analysis (and loosely calibrated to existing historical data)
• Monte Carlo Simulations of estimated cash inflows and outflows

Usage

Sovereign Credit Ratings are used widely for

• Internal policies, risk appetite, limits, credit risk assessment and other risk management applications
• Portfolio management
• Capital requirements

Alternatives

Market based estimates of implied credit risk from traded securities such as bonds, or sovereign credit default swaps

Issues and Challenges

• The lack of historical data means that methodologies involve a significant degree of subjectivity (which on occasion is also designated as bias)
• Controversially, under Basel II capital rules banks assign zero risk weights to the sovereign exposures of developed economies

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