[imf] are credit default swap spreads high in emerging markets

8/7/2019 [IMF] Are Credit Default Swap Spreads High in Emerging Markets

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WP/03/242

Are Credit Default Swap Spreads High inEmerging Markets? An Alternative

Methodology for Proxying RecoveryValue

Manmohan Singh


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2003 International Monetary Fund WP/03/242

IMF Working Paper

International Capital Markets Department

Are Credit Default Swap Spreads High in Emerging Markets? An Alternative

Methodology for Proxying Recovery Value

Prepared by Manmohan Singh1

Authorized for distribution by Donald J. Mathieson

December 2003

Abstract

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

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 EmergingMarkets (EM); traders only quote the CDS spreads and not the inputs that are required to calculate suchspreads. This note provides some evidence from Argentina and Brazil that reveals inconsistency betweentheory and practice in pricing CDS spreads in EM. This note suggests an alternate methodology thatlinks CTD (cheapest-to-deliver) bonds to recovery values assumed in CDS contracts. Furthermore,special features that pertain to CDS contracts (repo specialness, short squeezes by central banks) mayalso magnify the financial distress of a sovereign.

JEL Classification Numbers: F3, F34, G15, K33, K41

Keywords: recovery value, credit default swaps, cheapest-to-deliver bonds

Authors E-Mail Address: [email protected]

1 This paper has benefited from comments by Jane Brauer, Ben Miller, Hung Tran,Donald Mathieson, and participants in the seminars held by ICM, WHD, and RES. Any errorsor omissions remain my own.


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Contents

I. Correlation Between Recovery Value and Probability of Default .........................................3

II. An Alternate Methodology: The Cheapest-to-Deliver Bonds for Argentina and Brazil .......4III. Implication of CDS Spreads for Distressed Emerging Markets ...........................................6Figures1. Credit Default Swap in Practice .............................................................................................32. Argentine Bonds at Default ...................................................................................................43. Default Probabilities using Cheapest-to-Deliver Bonds.........................................................5

4. Brazils CDS Spreads in 2002 ................................................................................................5References....................................................................................................................................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 EmergingMarkets (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 inconsistencybetween theory and practice in pricing CDS spreads in EM. This note suggests an alternatemethodology that links CTD (cheapest to deliver) bonds to recovery values assumed in CDS

contracts.

I. CORRELATION BETWEEN RECOVERY VALUE AND PROBABILITY OF DEFAULT

The assumptions underlying the correlation between recovery value r, and the probability of default pis key to understanding CDS spreads. At a theoreticallevel, it is clear that CDS spreads are a jointfunction of the r and the p where both r and p are determined jointly; in other words, the correlationbetween r and p is not zero.2 Discussions with traders in EM reveal that in practice r is usually fixedat roughly 20 cents of the face (or par) value. Mathematically, using r as a constant will result in the

correlation of r and p to be zero. Also, empirically evidence from the corporate literature has shown(not surprising) that r is inversely correlated to p. The correlation between r and p cannot be zero inEM when theory and corporate literature suggest that r and p are negatively correlated.

Figure 1. Credit Default Swap in Practice

Source: Bloomberg, L.P.Figure 1 shows CDS spreads (s) =f (r, p) and explains how CDS works in 3 components:r is the recovery value at default, p is the probability of default; and s is

2 Mathematically, the correlation between two variables, where one is a constant, is zero.


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the premium per dollar of notational protection from time zero to T that solves the followingequation:

Wherep(t) = risk-neutral default probability;r = expected recovery rate on the reference obligation in a risk-neutral world;s = premium per dollar of notational protection from time zero to T;u(t) = the present value (PV ) of payments at the rate of $1 per year on payment dates between

zero and te(t) = PV on an accrual payment at time t, with payment equal to t-tl,

(where tl is last payment date)v(t) = PV of $1 received in time t

A (t) = accrued interest on the reference obligation at time t

II. AN ALTERNATE METHODOLOGY:THE CHEAPEST-TO-DELIVERBONDS FOR

ARGENTINA AND BRAZIL

A CDS contract usually refers to a few bonds in a basket of bonds at the time of the contract,allowing the protection seller a valuable option to deliver the cheapest bond upon a default (or, acredit event). These cheapest-to-deliver (CTD) bondsor reference bondsare generally priced at adiscount to other similar bonds due to their illiquidity, denomination, legal jurisdiction, and otherspecial features (interest-capitalization). Figure 2, illustrates the case ofArgentina where, at default,bond prices varied considerably between 24 cents and 38 cents, with the euro denominated issues

priced higher owing to large retail ownership in Europe.

Figure 2. Argentine Bonds at Default

Argentina Recovery Values

Average Dirty Mid-price in Jan 2002 vs. Remaining Average life, years

20%

22%

24%

26%

28%

30%

32%

34%

36%

38%

0 5 10 15 20 25 30 35

EU R

US D

Brady

USD Restr

FR B

'06s

'18s'31s

Source: Credit Suisse First Bost on

Cheapest to deliver

Case Study: ArgentinaCase Study: Argentina

( ) ( )[ ] ( )

( )( )[ ] ( )dttvtptAr

Tudttpsdttetutsp

T

TT

)(11

)(1)(

0

00

+

=

++


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Figure 3illustrates Argentine CDS spreads and decomposes them into their two components r and p.In this example, r is not assumed to be a constant and the CTD bond is a proxy for r; the Argentine2018 was used in most contracts as the CTD bond along with the Argentine samurai/yen issues. Notethat bond prices do not necessarily collapse at default. The prices of the Argentine CTD bondactually rose from about 24 cents to 28 cents owing to the cross default clauses when the Argentinedefault occurred.

Figure 3. Argentine Default Probabilities Using Cheapest-to-Deliver Bonds

0

10

20

30

40

50

60

70

80

90

6 /6 / 01 6 /1 8 /0 1 7 / 19 / 01 7 / 27 /0 1 8 / 6/ 0 1 8 / 15 / 01 8 /2 3 /0 1 9 / 5/ 0 1 1 0 /2 / 01 1 0 /1 5 /0 1 10 /2 5 /0 1 1 1 /2 /0 1 1 1 /1 3 /0 1 1 1 /2 6 /0 1 1 2 /7 / 01 1 2 /2 0 /0 1

1-year

default

probability

2-year

default

probability

A rgen t ina 2018 - C TD

Default Probabi l i t ies from the Credit Default Swa p spreads and the cheapest to de l iver bond

source: Merrill Lynch and staff estimates

Another example illustrates that Brazils CTD bonds were a better proxy for r. The CTD bondincreased about 30 percent from 37 cents to the dollar to 49 cents to the dollar in the monthsurrounding the election in October, 2002 (figure 4). This increase led to CDS spreads to tighten from

more than 4,500 basis points to less than 3500 basis points during the period. Holding recovery valueconstant (at say 20) would force the CDS spreads to be driven only by the probability of default.

However, consistent with the derivation of the CDS equation, the 1,000 bps tightening in CDScontract around the elections was also caused by the roughly 30 percent increase in the price of theCTD bond

Figure 4. Brazilian CDSSpreads (2002)

0

1000

2000

3000

4000

5000

6000

3/13/02 4/13/02 5/13/02 6/13/02 7/13/02 8/13/02 9/13/02 10/13/02 11/13/02 12/13/02 1/13/03

0

1000

2000

3000

4000

5000

6000

EMBI+ Brazil

Credit Default

Swap 1 2M

Credit Default

Swap 2 yr


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III. IMPLICATION OF CDSSPREADS FORDISTRESSED EMERGING MARKETS

Mispricing of CDSs magnifies the financial distress of a sovereign. During July/August 2002, the

EMBI+ sub-index for Brazil widened to just over 2,000 bps. During the same period, the CDSspreads for Brazil reached 4,500 bps, largely owing to squeeze on some short bonds (the 2004s andthe EIs ) and other factors such as repo specialness.3 CDS spread widening were leading indicators tosell-offs in the underlying bonds i.e., CDS market were driving the EMBI+ sub index (the tail wagsthe dog ). Recent experience with bonds traded on the mature markets (Weyerhauser, Ford etc) alsoindicate that CDS spreads provide valuable information (about insider trading, etc) and are a leadingindicator of financial distress. CDS spreads are also more volatile than the spreads on the underlyingasset CDS contracts require the insurer to cover the loss to par (that is par minus recovery value),while at default the bondholders loss is the value of the bond minus its recovery value (where, fordistressed assets, the value of bond is well below par). In other words, the likelihood of loss issignificantly larger for a CDS insurer than for an investor holding a particular bond.

This note concludes (i) that not linking recovery value to CTD bonds may lead to overpricing CDSspreads; and (ii) conjectures that there are special features that pertain to CDS contracts (repospecialness, short squeezes by central banks) that magnify the financial distress.

3 Market sources indicate that the Central Bank also bought most of the Brazilian Yen bonds to further squeezethe market for CTD bonds that led to higher CDS prices.


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ReferencesCredit Suisse First Boston, 2002, Emerging Market Sovereign Strategy, various issues.Hu, Yen-Ting, and Perraudin, William, 2002, The Dependence of Recovery Rates and

Defaults, Birbeck College and Bank of England, Working Paper.Jarrow, R.A., Lando, D., and Turnbull, S.M., 1997, A Markov Model for the Term Structure

of Credit Spreads, Review of Financial Studies, 10, pp. 481523.Kijima, M., and Komoribayashi, K., 1998, A Markov chain model for valuing credit risk

derivatives, Journal of Derivatives, 6 (1), pp. 9798.Merrick, John J. Jr., 2001, Crisis Dynamics of Implied Default Recovery Ratios: Evidence

from Russia and Argentina. Journal of Banking and Finance, 25, 1921-1939.

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