Quantifying sovereign risk in the euro area

The choice of the optimal sovereign risk indicator is crucial in the context of the euro area (EA) countries, which faced a fierce sovereign debt crisis. Traditional indicators of sovereign risk (CDS, bond yields, and credit rating) do not take into consideration the priority structure of creditors and are highly influenced by market sentiment. We propose a new indicator (distance to default, DtD) to quantify sovereign risk for eleven EA countries over the period 2004Q1-2019Q4. Using contingent claims? methodology, DtD incorporates the seniority structure of creditors in an existing theoretical model. Our results suggest that (1) DtD is a leading indicator of sovereign risk and (2) adding information from the public sector?s balance sheet structure to market information, helps better incorporate macroeconomic fundamentals in the sovereign risk measure, overcoming some of the weaknesses documented in the traditional indicators.