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The Pricing of Credit Default Swaps During Distress

by Jochen Andritzky of the International Monetary Fund, and
Manmohan Singh of the International Monetary Fund

November 2006

Abstract: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. 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 Brazil'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.

JEL Classification: F34, G12, G15.

Keywords: Credit default swaps, Brazil, recovery value, default risk.

Published in: Journal of Investment Management, Vol. 5, No. 4, (4th Qtr 2007), pp. 79-95.

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