49 Pages Posted: 24 Dec 2001
In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model with a constant recovery rate outperforms the market practice of directly comparing bonds' credit spreads to default swap premiums. We find that the model works well for investment grade credit default swaps, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is insensitive to the value of the assumed recovery rate.
Keywords: credit default swaps, credit derivatives, credit risk, default risk, risk-neutral valuation, default-free interest rates
JEL Classification: G12, G13, C13
Suggested Citation: Suggested Citation
Houweling, Patrick and Vorst, Ton, Pricing Default Swaps: Empirical Evidence. Journal of International Money and Finance, Vol. 24, pp. 1200-1225, 2005; EFA 2002 Berlin Meetings Presented Paper; EFMA 2002 London Meetings; ERIM Report Series. Available at SSRN: https://ssrn.com/abstract=294799 or http://dx.doi.org/10.2139/ssrn.294799