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In Rememberance: World Trade Center (WTC)

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Pricing Default Swaps: Empirical Evidence

by Patrick Houweling of Erasmus University Rotterdam and Rabobank Int'l, and
Ton Vorst of Erasmus University Rotterdam and ABN Amro

December 2005

Abstract: In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model outperforms directly comparing bonds' credit spreads to default swap premiums. We find that the model yields unbiased premium estimates for default swaps on investment grade issuers, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is relatively insensitive to the value of the assumed recovery rate.

JEL Classification: C13, G12, G13.

Keywords: credit default swaps, credit risk, default risk, recovery rates, reduced form models.

Published in: Journal of International Money and Finance, Vol. 24, No. 8, (December 2005), pp. 1200-1225.

Previously titled: An Empirical Comparison of Default Swap Pricing Models

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