I. Correlation Between Recovery Value and Probability of Default .........................................3
II. An Alternate Methodology: The Cheapest-to-Deliver Bonds for Argentina and Brazil .......4
III. Implication of CDS Spreads for Distressed Emerging Markets ...........................................6
Figures
1. Credit Default Swap in Practice .............................................................................................3
2. Argentine Bonds at Default ...................................................................................................4
3. Default Probabilities using Cheapest-to-Deliver Bonds .........................................................5
4. Brazil¡¯s CDS Spreads in 2002 ................................................................................................5
References...................................................................................................................................7
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An Alternative Methodology for Proxying Recovery Value in Credit Default Swap Contracts
In times of distress when a country loses access to markets, there is evidence that credit default swap
(CDS) spreads are a leading indicator for sovereign risk than the EMBI+ sub-index for the country.
However, it is not easy to discern the variables that determine the level of CDS spreads in Emerging
Markets (EM); traders only quote the CDS spreads and not the inputs that are required to calculate
such spreads. This note provides some evidence from Argentina and Brazil that reveals inconsistency
between theory and practice in pricing CDS spreads in EM. This note suggests an alternate
methodology that links CTD (cheapest to deliver) bonds to recovery values assumed in CDS
...