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The Pricing of Credit Default Swaps During Distress

  • Manmohan Singh
  • Jochen R. Andritzky

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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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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  1. 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.).
  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. Didier Cossin & Tomas Hricko & Daniel Aunon-Nerin & Zhijiang Huang, 2002. "Exploring for the Determinants of Credit Risk in Credit Default Swap Transaction Data: Is Fixed-Income Markets’ Information Suffcient to Evaluate Credit Risk?," FAME Research Paper Series rp65, International Center for Financial Asset Management and Engineering.
  4. Franck Packer & Haibin Zhu, 2005. "Contractual terms and CDS pricing," BIS Quarterly Review, Bank for International Settlements, March.
  5. Frank Packer & Chamaree Suthiphongchai, 2003. "Sovereign credit default swaps," BIS Quarterly Review, Bank for International Settlements, December.
  6. Amadou N. R. Sy & Andrea Pescatori, 2004. "Debt Crises and the Development of International Capital Markets," IMF Working Papers 04/44, International Monetary Fund.
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