February 27, 2017

MFE Students Win National Sovereign Credit Risk Modeling Competition

A diverse group of Master of Financial Engineering students from five countries and five professions bested 26 competitors to win first place in a competition that required developing a sovereign credit risk model. 

The winning team, announced Feb. 2, consisted of (clockwise from bottom left) Xin Heng, Ji Tan, Michael Pensky, Don Goonetilleke, team captain Charles Gorintin, and Yang Guo, all MFE 12. The team won $1,000 and an invitation to present its solution at a New York event of the International Association of Financial Engineers, the nonprofit professional society that sponsored the competition. 
The team spent six weeks on its model while working full-time internships in Boston, San Francisco, New York, and London, relying on weekend conference calls to coordinate efforts. The students attributed their success to their MFE classes and their variety of backgrounds.
"This paper really was a combination of everything we learned in the MFE Program," says Pensky. "We were able to apply what we learned from several classes." Those classes included Derivatives, Advanced Computational Finance, Empirical Methods, and Credit Risk.
The students also brought diverse backgrounds to the team. Citizenships represented were China, Russia, the U.S., Australia, and France. Their academic backgrounds included physics, biology, finance, mathematics, and actuarial sciences. "The wide variety helped us think about the same problem from different directions," says Gorintin, who is from France.
The competition asked participants to develop a model, algorithm, or technique to provide a replicable, internally consistent sovereign credit rating and a means for predicting changes to that rating. Then they were asked to apply their methodology to Greece and California and detail how they would hedge credit risk for both entities.
Sovereign debt refers to government debt issued by a sovereign entity, whether it's a country like Greece or a state like California. The competition aimed to improve analysis and modeling of financial crises and financial risk amid growing concerns about increases in sovereign credit risk, brought to the fore by recent events in Greece.
"The innovative idea in this paper is that we were able to model the cross behavior between a state and its encompassing monetary union, as each one strives to maximize its own probability of survival," says Pensky, noting that the team built on a model developed by Nobel laureate and MIT Sloan Professor Robert Merton in 1973. 
The students’ model suggests that if a state is weak and a union is weakened, though slightly stronger, the union is most likely to bail out the state because it fears contagion. However, a very strong union is less likely to bail out a weak state because it will not fear contagion as a state’s default should do little to harm its stability. (Think California and Orange County in the 1990s.) In addition, a union that is very weak will not bail out the state because it is too weak to do so and the action would bring little benefit in increasing its probability of survival.

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