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The Use (and Abuse) of CDS Spreads During Distress

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  • Carolyne Spackman
  • Manmohan Singh
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    Abstract

    Credit Default Swap spreads have been used as a leading indicator of distress. Default probabilities can be extracted from CDS spreads, but during distress it is important to take account of the stochastic nature of recovery value. The recent episodes of Landbanski, WAMU and Lehman illustrate that using the industry-standard fixed recovery rate assumption gives default probabilities that are low relative to those extracted from stochastic recovery value as proxied by the cheapest-to-deliver bonds. Financial institutions using fixed rate recovery assumptions could have a false sense of security, and could be faced with outsized losses with potential knock-on effects for other institutions. To ensure effective oversight of financial institutions, and to monitor the stability of the global financial system especially during distress, the stochastic nature of recovery rates needs to be incorporated.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 09/62.

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    Length: 13
    Date of creation: 01 Mar 2009
    Date of revision:
    Handle: RePEc:imf:imfwpa:09/62

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    Related research

    Keywords: Financial institutions; Credit risk; Risk premium; Bankruptcy; bond; bonds; probability; probabilities; bond prices; derivative; financial system; bond market; bond price; cash bond market; hedge funds; hedge; cash bonds; bond markets; hedging; financial sector; correlation;

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    1. Houweling, Patrick & Vorst, Ton, 2005. "Pricing default swaps: Empirical evidence," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1200-1225, December.
    2. Jun Pan & Kenneth J. Singleton, 2008. "Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads," Journal of Finance, American Finance Association, vol. 63(5), pages 2345-2384, October.
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