## Are Credit Default Swap Spreads High in Emerging Markets? An Alternative Methodology for Proxying Recovery Value

## Source details

**Canonical URL:** [Are Credit Default Swap Spreads High in Emerging Markets? An Alternative Methodology for Proxying Recovery Value](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2003/_wp03242.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2003/_wp03242.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2003/_wp03242.pdf.json)

---

### I. Correlation Between Recovery Value and Probability of Default
- Theoretical relation: CDS spreads s = f(r, p) where r is the recovery value and p is the probability of default; r and p are determined jointly (correlation between r and p is not zero).
- Practical observation in Emerging Markets (EM): traders typically fix r at roughly 20 cents of face (par) value.
- Mathematical implication: using r as a constant implies the correlation of r and p is zero.
- Empirical/corporate literature: r is inversely correlated to p (i.e., r and p are negatively correlated).
- Conclusion: In EM, theory and corporate literature suggest r and p are negatively correlated; assuming constant r (as practice often does) is inconsistent with theory and empirical corporate evidence.

Key variables and definitions from the CDS pricing framework shown:
- p(t) = risk-neutral default probability;
- r = expected recovery rate on the reference obligation in a risk-neutral world;
- s = premium per dollar of notational protection from time zero to T;
- u(t) = present value (PV) of payments at the rate of $1 per year on payment dates between zero and t;
- e(t) = PV on an accrual payment at time t, with payment equal to t − t_l (where t_l is last payment date);
- v(t) = PV of $1 received in time t;
- A(t) = accrued interest on the reference obligation at time t.

### II. An Alternate Methodology: The Cheapest-to-Deliver Bonds for Argentina and Brazil
- CDS contracts typically reference a basket of bonds and give the protection seller the option to deliver the cheapest-to-deliver (CTD) bond upon a credit event.
- CTD bonds are generally priced at a discount to other similar bonds due to illiquidity, denomination, legal jurisdiction, and special features (e.g., interest-capitalization).
- Proposal: use CTD bond prices as a proxy for recovery value r rather than fixing r at a constant.

Case study — Argentina:
- At default, Argentine bond prices varied between 24 cents and 38 cents; euro-denominated issues were priced higher due to large retail ownership in Europe.
- The Argentine 2018 was used in most contracts as the CTD bond along with samurai/yen issues.
- Observed behavior: prices of the Argentine CTD bond rose from about 24 cents to 28 cents owing to cross-default clauses when the Argentine default occurred.
- Using CTD bond as proxy for r allows decomposition of CDS spreads into r and p without assuming r constant.

Case study — Brazil:
- The CTD bond price increased about 30 percent from 37 cents to the dollar to 49 cents to the dollar in the month surrounding the October, 2002 election.
- This roughly 30 percent increase in the CTD price coincided with about a 1,000 bps tightening in CDS spreads (from more than 4,500 basis points to less than 3,500 basis points) during the period.
- Holding recovery value constant (e.g., at 20) would force CDS spreads to be driven only by the probability of default; observed CTD movements imply both r and p contributed to CDS spread changes.

### III. Implication of CDS Spreads for Distressed Emerging Markets
- Mispricing or incorrect proxying of recovery values in CDS contracts can magnify a sovereign’s financial distress.
- Example — Brazil July/August 2002:
  - EMBI+ sub-index for Brazil widened to just over 2,000 bps.
  - CDS spreads for Brazil reached 4,500 bps, largely owing to squeezes on some short bonds (the 2004s and the EIs) and repo specialness.
  - CDS widening acted as a leading indicator to sell-offs in underlying bonds (CDS market drove the EMBI+ sub-index — “the tail wags the dog”).
- CDS spreads are more volatile than spreads on the underlying asset because:
  - CDS insurer covers loss to par (par minus recovery value).
  - At default, a bondholder’s loss is bond value minus recovery value, and for distressed assets bond value is well below par.
  - Thus, likelihood (and magnitude) of loss for a CDS insurer can be significantly larger than for an investor holding the bond.
- Special features that can magnify distress in CDS markets include:
  - Repo specialness.
  - Short squeezes (including actions by central banks that can squeeze the market for CTD bonds).
- Concluding points:
  - Not linking recovery value to CTD bonds may lead to overpricing CDS spreads.
  - Special features that pertain to CDS contracts (repo specialness, short squeezes by central banks) may magnify financial distress.

*Source: WP/03/242 — Are Credit Default Swap Spreads High in Emerging Markets? An Alternative Methodology for Proxying Recovery Value (Manmohan Singh, December 2003).*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2003/_wp03242.pdf_