Sovereign Default Risk and Recovery Rates: What Government Bond Markets Expect for Greece

Abstract

Bond market data on sovereign bond yields is used to estimate sovereign default risk and the amount of the expected “hair‐cut” for Greece between 2008 and 2011. Using a structural pricing model that relies on compound option theory short‐term and long‐term default probabilities and their dependencies can be inferred. Thereby bond yield spreads for different maturities are integrated. In addition, a reduced form model is applied to infer the recovery rate expected by bond market participants. The paper shows that sovereign default risk and recovery rate dynamics reflect events that are important for Greece's repayment capacity.