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Anticipating Credit Events Using Credit Default Swaps, with an Application to Sovereign Debt Crises

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  • Jorge A. Chan-Lau

Abstract

In reduced-form pricing models, it is usual to assume a fixed recovery rate to obtain the probability of default from credit default swap prices. An alternative credit risk measure is proposed here: the maximum recovery rate compatible with observed prices. The analysis of the recent debt crisis in Argentina using this methodology shows that the correlation between the maximum recovery rate and implied default probabilities turns negative in advance of the credit event realization. This empirical finding suggests that the maximum recovery rate can be used for constructing early warning indicators of financial distress.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 03/106.

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Length: 6
Date of creation: 01 May 2003
Date of revision:
Handle: RePEc:imf:imfwpa:03/106

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  1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Ian Marsh, 2002. "What central banks can learn about default risk from credit markets," BIS Papers chapters, in: Bank for International Settlements (ed.), Market functioning and central bank policy, volume 12, pages 329-339 Bank for International Settlements.
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Cited by:
  1. Ciarlone, Alessio & Trebeschi, Giorgio, 2005. "Designing an early warning system for debt crises," Emerging Markets Review, Elsevier, vol. 6(4), pages 376-395, December.
  2. Monfort, A. & Renne, J-P., 2011. "Credit and liquidity risks in euro area sovereign yield curves," Working papers 352, Banque de France.
  3. Andrea Pescatori & Amadou N R Sy, 2007. "Are Debt Crises Adequately Defined?," IMF Staff Papers, Palgrave Macmillan, vol. 54(2), pages 306-337, June.
  4. Amadou N. R. Sy & Andrea Pescatori, 2004. "Debt Crises and the Development of International Capital Markets," IMF Working Papers 04/44, International Monetary Fund.
  5. Jorge A. Chan-Lau, 2006. "Market-Based Estimation of Default Probabilities and Its Application to Financial Market Surveillance," IMF Working Papers 06/104, International Monetary Fund.
  6. Dale F. Gray & Robert C. Merton & Zvi Bodie, 2006. "A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy," NBER Working Papers 12637, National Bureau of Economic Research, Inc.

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