Sovereign Risk Indices and Bayesian Theory Averaging

TL;DR

This paper introduces a Bayesian model averaging approach to create latent theory indices for sovereign risk, accommodating multiple proxies and outcome types to improve macroeconomic risk assessment.

Contribution

It develops a novel methodology for constructing generalizable, theory-based risk indices using Bayesian model averaging and flexible models across multiple outcome equations.

Findings

Successful calibration of sovereign risk indices across various collapse criteria

Indices effectively differentiate countries based on macroeconomic risk

Framework accommodates non-Gaussian outcomes and differential theory relevance

Abstract

In economic applications, model averaging has found principal use examining the validity of various theories related to observed heterogeneity in outcomes such as growth, development, and trade.Though often easy to articulate, these theories are imperfectly captured quantitatively. A number of different proxies are often collected for a given theory and the uneven nature of this collection requires care when employing model averaging. Furthermore, if valid, these theories ought to be relevant outside of any single narrowly focused outcome equation. We propose a methodology which treats theories as represented by latent indices, these latent processes controlled by model averaging on the proxy level. To achieve generalizability of the theory index our framework assumes a collection of outcome equations. We accommodate a flexible set of generalized additive models, enabling non-Gaussian outcomes to be included. Furthermore, selection of relevant theories also occurs on the outcome level, allowing for theories to be differentially valid. Our focus is on creating a set of theory-based indices directed at understanding a country's potential risk of macroeconomic collapse. These Sovereign Risk Indices are calibrated across a set of different "collapse" criteria, including default on sovereign debt, heightened potential for high unemployment or inflation and dramatic swings in foreign exchange values. The goal of this exercise is to render a portable set of country/year theory indices which can find more general use in the research community.