Anticipating Credit Events Using Credit Default Swaps, with an Application to Sovereign Debt Crises

20 Pages Posted: 21 Jul 2003

See all articles by Jorge A. Chan-Lau

Jorge A. Chan-Lau

International Monetary Fund (IMF) - International Capital Markets Department; National University of Singapore (NUS) - Risk Management Institute; Tufts University - Fletcher School of Law and Diplomacy

Date Written: May 2003

Abstract

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.

Keywords: Credit default swaps, maximum recovery rate, default probability, sovereign risk

JEL Classification: G0, G15

Suggested Citation

Chan-Lau, Jorge Antonio, Anticipating Credit Events Using Credit Default Swaps, with an Application to Sovereign Debt Crises (May 2003). IMF Working Paper No. 03/106. Available at SSRN: https://ssrn.com/abstract=414361 or http://dx.doi.org/10.2139/ssrn.414361

Jorge Antonio Chan-Lau (Contact Author)

International Monetary Fund (IMF) - International Capital Markets Department ( email )

700 19th Street NW
Washington, DC 20431
United States

National University of Singapore (NUS) - Risk Management Institute ( email )

21 Heng Mui Keng Terrace
Level 4
Singapore, 119613
Singapore

Tufts University - Fletcher School of Law and Diplomacy ( email )

160 Packard Ave
Medford, MA 02155
United States

HOME PAGE: http://fletcher.tufts.edu/ceme/index.shtml

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