The Use (and Abuse) of CDS Spreads During Distress
IMF Working Papers, March 1, 2009
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- The Use (and Abuse) of CDS Spreads During Distress
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Bibliographic details
- Authors: Carolyne Spackman, Manmohan Singh
- Published: March 1, 2009
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451872095.001
Summary
- Credit Default Swap spreads have been used as a leading indicator of distress.
- Default probabilities can be extracted from CDS spreads, but during distress it is important to take account of the stochastic nature of recovery value.
- Recent episodes of Landbanski, WAMU and Lehman illustrate that using the industry-standard fixed recovery rate assumption gives default probabilities that are low relative to those extracted from stochastic recovery value as proxied by the cheapest-to-deliver bonds.
- Financial institutions using fixed rate recovery assumptions could have a false sense of security, and could be faced with outsized losses with potential knock-on effects for other institutions.
- To ensure effective oversight of financial institutions, and to monitor the stability of the global financial system especially during distress, the stochastic nature of recovery rates needs to be incorporated.
Key findings and evidence
- Using a fixed recovery rate assumption (industry standard) understates default probabilities during distress compared with models that incorporate stochastic recovery value.
- Cheapest-to-deliver (CTD) bond prices can be used to proxy stochastic recovery value and yield higher implied default probabilities than fixed-recovery models.
- Episodes cited as illustrative: Landbanski, WAMU, Lehman.
Policy implications and recommendations
- Supervisors and financial institutions should incorporate the stochastic nature of recovery rates into models used for:
- Extracting default probabilities from CDS spreads.
- Risk assessment and capital planning during distress.
- Reliance on fixed recovery assumptions can create a false sense of security and increase systemic risk through underestimated counterparty exposures.
- Monitoring frameworks for the stability of the global financial system should include stochastic recovery-rate considerations, particularly in periods of heightened distress.
Subject classification and keywords
- Subject: Asset prices, Bonds, Credit, Credit default swap, Currencies, Financial institutions, Money, Prices
- Keywords: Asset prices; Bonds; CDS contract; CDS market; CDS settlement; CDS spread; CDS spreads during distress; cheapest-to-deliver bonds; Credit; Credit default swap; credit event; CTD bond price information; Currencies; Global; market; probability of default; stochastic recovery rate; value; WP