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

Jorge Chan-Lau

No 2003/106, IMF Working Papers from International Monetary Fund

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: WP; default; default probability; Credit default swaps; maximum recovery rate; sovereign risk; CDS market; term structure; CDS spread; recovery rate; credit default swap price; Credit default swap; Credit; Yield curve; Credit risk; Global (search for similar items in EconPapers)
Pages: 20
Date: 2003-05-01
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Citations: View citations in EconPapers (14)

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