Market Expectations and Default Risk Premium in Credit Default Swap Prices: A Case Study of Argentine Default

Abstract

This article explores expectations of credit market and default risk premium implicit in credit default swap prices in the case of Argentine default. We find that default risk premium is substantial and its relation with default probability is not monotone. Default risk premium increases with a rising default probability when default probability is low, but it declines when default probability reaches a certain level and continues to rise. This result suggests that default risk premium plays a primary role in the pricing of credit derivatives when default risk is moderate, but its impact becomes secondary when default risk becomes extremely high. We also find default risk premium has a hump-shaped term structure with the peak of the curve around five to six years. Our results show that variation in default risk premium in Argentine sovereign debt was affected by changes in the U.S. business cycle and credit conditions and the overall strength of the Argentine economy. Comparing with market expected default probabilities, we find that major rating agencies assigned overly optimistic ratings to Argentine debt and they lagged the market in downgrading the debt.

Keywords: Credit default swap, default risk, risk premium, market expectation, credit derivatives, sovereign debt, Argentina, default probability, term structure

JEL Classification: G12, G13, G15