Are Credit Default Swaps Spreads High in Emerging Markets: An Alternative Methodology for Proxying Recovery Value

IMF Working Papers, December 1, 2003

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In times of distress when a country loses access to markets, there is evidence that credit default swap (CDS) spreads are a leading indicator for sovereign risk than the EMBI+ sub-index for the country.
It is not easy to discern the variables that determine the level of CDS spreads in Emerging Markets (EM); traders only quote the CDS spreads and not the inputs that are required to calculate such spreads.
The note provides evidence from Argentina and Brazil that reveals inconsistency between theory and practice in pricing CDS spreads in EM.
The note suggests an alternate methodology that links CTD (cheapest-to-deliver) bonds to recovery values assumed in CDS contracts.
Special features that pertain to CDS contracts (repo specialness, short squeezes by central banks) may also magnify the financial distress of a sovereign.

Country cases examined: Argentina and Brazil.
Key empirical observation: CDS spreads can lead sovereign-risk indicators such as the EMBI+ sub-index when a country loses market access.
Identified gap: Market quotes provide CDS spreads but not the underlying inputs required to calculate theoretical CDS spreads, creating difficulty reconciling observed spreads with model-implied values.

Proposed alternative methodology: Link CTD (cheapest-to-deliver) bonds to recovery values assumed in CDS contracts.
Rationale: Using CTD bonds as a proxy provides a way to infer recovery values embedded in market CDS spreads where direct inputs are unobserved.

Repo specialness of certain bonds.
Short squeezes by central banks.
These special features can magnify financial distress of a sovereign beyond what standard CDS-pricing models may predict.