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The Pricing of Credit Default Swaps During Distress

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Author Info

  • Manmohan Singh
  • Jochen R. Andritzky

Abstract

Credit default swaps (CDS) provide the buyer with insurance against certain types of credit events by entitling him to exchange any of the bonds permitted as deliverable against their par value. Unlike bonds, whose risk spreads are assumed to be the product of default risk and loss rate, CDS are par instruments, and their spreads reflect the partial recovery of the delivered bond''s face value. This paper addresses the implications of the difference between bond and CDS spreads and shows the extent to which the recovery assumption matters for determining CDS spreads. A no-arbitrage argument is applied to extract recovery rates from CDS and bond markets, using data from Brazil''s distress in 2002-03. Results are related to the observation that preemptive restructurings are now more common than straight defaults in sovereign bond markets and that this leads to a decoupling of CDS and bond spreads.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/254.

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Length: 23
Date of creation: 01 Nov 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/254

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Related research

Keywords: Credit risk; Risk premium; Prices; bond; bonds; arbitrage; bond market; bond spreads; bond price; bond spread; cash bonds; bond prices; cash bond market; bond markets; sovereign bond; sovereign bond markets; hedge; sovereign bonds; sovereign bond market; present value; cash flow; bond instruments; bond valuation; common bond; international capital; international financial markets; bond issues; net present value; international capital markets; corporate bonds; risk aversion; underinsured; cash flows; financial markets; corporate bond; derivative; option markets;

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References

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  1. Frank Packer & Chamaree Suthiphongchai, 2003. "Sovereign credit default swaps," BIS Quarterly Review, Bank for International Settlements, December.
  2. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2004. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit-Default Swap Market," NBER Working Papers 10418, National Bureau of Economic Research, Inc.
  3. Amadou N. R. Sy & Andrea Pescatori, 2004. "Debt Crises and the Development of International Capital Markets," IMF Working Papers 04/44, International Monetary Fund.
  4. Frank X. Zhang, 2003. "What did the credit market expect of Argentina default? Evidence from default swap data," Finance and Economics Discussion Series 2003-25, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:
  1. Michael Adler & Jeong Song, 2010. "The behavior of emerging market sovereigns' credit default swap premiums and bond yield spreads," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 15(1), pages 31-58.
  2. Christoph Trebesch & Michael G Papaioannou & Udaibir S. Das, 2012. "Sovereign Debt Restructurings 1950-2010," IMF Working Papers 12/203, International Monetary Fund.
  3. Christoph Trebesch, 2009. "The Cost of Aggressive Sovereign Debt Policies," IMF Working Papers 09/29, International Monetary Fund.
  4. Ammer, John & Cai, Fang, 2011. "Sovereign CDS and bond pricing dynamics in emerging markets: Does the cheapest-to-deliver option matter?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 21(3), pages 369-387, July.
  5. Christian Capuano, 2008. "The Option-Ipod. the Probability of Default Implied by Option Prices Basedon Entropy," IMF Working Papers 08/194, International Monetary Fund.

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