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

Author/Editor:

Jorge A Chan-Lau

Publication Date:

May 1, 2003

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

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.

Series:

Working Paper No. 2003/106

Subject:

English

Publication Date:

May 1, 2003

ISBN/ISSN:

9781451852912/1018-5941

Stock No:

WPIEA1062003

Pages:

20

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