Anticipating Credit Events Using Credit Default Swaps, with An Application to Sovereign Debt Crises
May 1, 2003
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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.
Subject: Credit, Credit default swap, Credit risk, Financial crises, Financial regulation and supervision, Financial services, Money, Yield curve
Keywords: CDS market, CDS spread, Credit, Credit default swap, credit default swap price, Credit default swaps, Credit risk, default, default probability, Global, maximum recovery rate, recovery rate, sovereign risk, term structure, WP, Yield curve
Pages:
20
Volume:
2003
DOI:
Issue:
106
Series:
Working Paper No. 2003/106
Stock No:
WPIEA1062003
ISBN:
9781451852912
ISSN:
1018-5941
