A sovereign risk index for the Eurozone based on stochastic dominance

- A new method to assess sovereign risk in the Eurozone is proposed.
- It is based on consistent tests for stochastic dominance efficiency.
- Countries are ranked according to the risk indices.
- Policy implications and practical motivation of our indices are discussed.

We propose a new method to assess sovereign risk in Eurozone countries using an approach that relies on consistent tests for stochastic dominance efficiency. The test statistics and the estimators are computed using mixed integer programming methods. Our analysis is based on macroeconomic fundamentals and their importance in accounting for sovereign risk. The results suggest that net international investment position/GDP and public debt/GDP are the main contributors to country risk in the Eurozone. We also conduct ranking analysis of countries for fiscal and external trade risk. We find a positive correlation between our rankings of the most vulnerable countries and the S&P's ratings, whereas the correlation for other countries is weaker.