The Pricing of Credit Default Swaps During Distress

25 Pages Posted: 19 Jan 2007

See all articles by Jochen R. Andritzky

Jochen R. Andritzky

German Council of Economic Experts; International Monetary Fund (IMF)

Manmohan Singh

International Monetary Fund (IMF)

Date Written: November 2006

Abstract

Credit default swaps (CDS) provide the buyer with insurance against certain types of credit events by entitling him to exchange any of the bonds permitted as deliverable against their par value. Unlike bonds, whose risk spreads are assumed to be the product of default risk and loss rate, CDS are par instruments, and their spreads reflect the partial recovery of the delivered bond's face value. This paper addresses the implications of the difference between bond and CDS spreads and shows the extent to which the recovery assumption matters for determining CDS spreads. A no-arbitrage argument is applied to extract recovery rates from CDS and bond markets, using data from Brazilapos's distress in 2002-03. Results are related to the observation that preemptive restructurings are now more common than straight defaults in sovereign bond markets and that this leads to a decoupling of CDS and bond spreads.

Keywords: Credit risk, Brazil, Risk premium, Bond markets, Prices

JEL Classification: F34, G12, G15

Suggested Citation

Andritzky, Jochen and Singh, Manmohan, The Pricing of Credit Default Swaps During Distress (November 2006). IMF Working Paper No. 06/254, Available at SSRN: https://ssrn.com/abstract=958162

Jochen Andritzky

German Council of Economic Experts ( email )

Federal Statistical Office
Gustav-Stresemann-Ring 11
Wiesbaden, Hessen 65180
Germany

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

Manmohan Singh (Contact Author)

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

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