Modeling Sovereign Risk with Correlated Stochastic Processes (DRAFT VERSION)

In this work we use stochastic processes and correlation networks to model systemic risk between the economies of the European monetary union, in the post crisis period. For each country we consider, as a financial leverage measure, the Debt/GDP ratio. We then model the time dynamic of both the Debt and the GDP by means of a linear combination of two stochastic equations: an eurozone systematic process and a country specific idiosyncratic process. Doing so, we model debt sustainability from both the financial and the real side, and in terms of both common and country-specific factors. We provide an estimation model for the parameters of the processes, and we derive the implied default probabilities for each country. Systemic risk is estimated by means of the estimated partial correlation matrix that is a function of the estimated parameters.