Loss Given Default Implied by Cross - sectional No Arbitrage ∗

I develop various frameworks for the separation of loss given default and default intensity present in securities with credit risk. They include spot and forward credit default swaps, digital default swaps and bonds. Cross-sectional no-arbitrage restriction between different securities extracts the pure measure of default intensity and loss given default not contaminated by the other. Using spot and forward CDS premium data of 10 emerging market sovereigns, I find that 75% level of loss given default prevails in the sovereign CDS markets across countries over time. Positive correlation between loss given default and default intensity is only found in Brazil and Venezuela during the period of political turmoil in each country. This result is puzzling considering diverse fundamentals across countries and time variation of the marginal rate of substitution. Loss given default below (above) the 75% generates negative (positive) pricing errors in forward CDS and the magnitude of them is economically significant. This persistent negative (positive) pricing errors with mis-specified loss given default higher (lower) than the true one are consistent with the model developed. ∗The author would like to thank Joyce Chang, Global Head of Emerging Markets Research, Foreign Exchange, and Commodities at J.P. Morgan Securities, for affording him access to the JPMorgan Database.