The Pricing of Credit Default Swaps During Distress

IMF Working Papers, November 1, 2006

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Authors: Manmohan Singh, Jochen R. Andritzky
Date: November 1, 2006
Core question: Differences between bond and CDS spreads and the implications of recovery assumptions for determining CDS spreads.
Context: Uses data from Brazil's distress in 2002-03 and links findings to the increasing prevalence of preemptive restructurings in sovereign bond markets and the resulting decoupling of CDS and bond spreads.

CDS are par instruments whose spreads reflect the partial recovery of the delivered bond's face value, unlike bonds whose risk spreads are assumed to be the product of default risk and loss rate.
The recovery assumption materially affects the determination of CDS spreads.
A no-arbitrage argument can be applied to extract recovery rates from CDS and bond markets.
Empirical evidence is presented using data from Brazil's distress in 2002-03.
The increasing frequency of preemptive restructurings (relative to straight defaults) in sovereign bond markets contributes to a decoupling of CDS and bond spreads.

Analytical approach: No-arbitrage argument to extract recovery rates from CDS and bond markets.
Empirical case study: Brazil's distress in 2002-03.

Recovery assumptions used in pricing CDS are central to interpreting CDS spreads, especially during episodes of sovereign distress.
The shift toward preemptive restructurings in sovereign markets implies that CDS and bond spreads may no longer move in tandem; market participants and policymakers should account for this decoupling when assessing sovereign risk via market spreads.

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