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

  • Jorge A. Chan-Lau

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

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Length: 20
Date of creation: 01 May 2003
Date of revision:
Handle: RePEc:imf:imfwpa:03/106
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  1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
  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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