Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads

This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events (λ), but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with λ following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in λ are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy. THE BURGEONING MARKET FOR SOVEREIGN CREDIT DEFAULT SWAPS (CDS) contracts offers a nearly unique window for viewing investors’ risk-neutral probabilities of major credit events impinging on sovereign issuers, and their risk-neutral losses of principal in the event of a restructuring or repudiation of external debts. In contrast to many “emerging market” sovereign bonds, sovereign CDS contracts are designed without complex guarantees or embedded options. Trading activity in the CDS contracts of several sovereign issuers has developed to the point that they are more liquid than many of the underlying bonds. Moreover, in contrast to the corporate CDS market, where trading has been concentrated largely in the 5-year maturity contract, CDS contracts at several maturity points between 1 and 10 years have been actively traded for several years. As such, a full term structure of CDS spreads is available for inferring default and recovery information from market data. This paper explores in depth the time-series properties of the risk-neutral mean arrival rates of credit events (λ) implicit in the term structure of sovereign CDS spreads. Applying our framework to Mexico, Turkey, and Korea, three countries with different geopolitical characteristics and credit ratings, we ∗Pan is with the MIT Sloan School of Management and NBER. Singleton is with the Graduate School of Business, Stanford University and NBER. We have benefited from discussions with Antje Berndt, Darrell Duffie, Michael Johannes, Jun Liu, Francis Longstaff, Roberto Rigobon; seminar participants at Chicago, Columbia, CREST, Duke, USC, UCLA, University of Michigan, the 2005 NBER IASE workshop, the November 2005 NBER Asset Pricing meeting, the 2006 AFA Meetings, AQR, the 2007 Fed conference on credit risk and credit derivatives; and the comments of two anonymous referees. Scott Joslin provided excellent research assistance. We are grateful for financial support from the Gifford Fong Associates Fund at the Graduate School of Business, Stanford University and from the MIT Laboratory for Financial Engineering.