Fixing Fundamental Flaws in Probabilistic Country Risk Models
Bertrand Groslambert
Preface: Two economists’ views on the bank-sovereign linkage
Introduction
Assessing Country Risk: A Practical Guide
Sovereign Risk: Characteristics, History and a Review of Recent Research
The Arab Spring: Insights for Political Risk Analysis
The Eurozone Crisis: The Forgotten Risks of Private and External Debt
How the Eurozone Crisis Became a Banking Crisis, and the Risk of Japanisation
The Changing Dynamics of Country Risk
Capital Flight as a Political Risk Indicator
Debt Crisis Indicators of Emerging Markets versus Eurozone Economies
How Much Economic Capital Could European Banks Save? The Case for Optimal Sovereign Risk Allocation
Fixing Fundamental Flaws in Probabilistic Country Risk Models
Have We Learned the Country Risk Management Lessons of the 1997 Asian Financial Crisis?
Using Systems Thinking to Enhance Country Risk Assessment
Approaches to the Quantification of Country Risk
Stress Testing Across International Exposures and Activities
This chapter will demonstrate important flaws in the standard models and approaches used for country risk assessment and management that are based on assumptions of normal distributions. Based first on theory and then on an empirical review of data on market returns and foreign exchange prices, we propose an alternate and superior probabilistic approach as a basis for country risk management.
Risk can take different forms and can range from mild to wild randomness. Mild risk is when deviations from normal are typically small. In comparison, wild risk is characterised by extreme events, abrupt changes and large fluctuations. These types of risk have very different statistical characteristics, and it is therefore essential to first understand the true nature of country risk if one wants to try to manage it relying on statistical approaches.
The chapter is structured as follows. The first section will review the foundations of probabilistic risk assessment, briefly exploring the history of probability and presenting the origin of the normal law as a natural candidate for risk assessment. The second section will highlight the flaws of the normal law and explain how misleading it
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