Market Signals and the Cost of Credit Risk Protection: An Analysis of CDS Settlement Auctions

December 24, 2014

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Luisa Zanforlin, and Nobuyuki Kanazawa. Market Signals and the Cost of Credit Risk Protection: An Analysis of CDS Settlement Auctions, (USA: International Monetary Fund, 2014) accessed November 21, 2024

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

Summary

We study the link between the probability of default implied by Credit Default Swaps (CDS) spreads and the final prices of the defaulted bonds as established at the CDS settlement auctions. We observe that the post-default recovery rates at the observed spreads imply markets were often “surprised” by the credit event. We find that the prices of the bonds that are deliverable at the auctions imply probabilities of default that are systematically different than the default probabilities estimated prior to the event of default using standard methodologies. We discuss the implications for CDS pricing models. We analyze the discrepancy between the actual and theoretical CDS spreads and we find it is significantly associated both to the CDS market microstructure at the time of the settlement auction and to the general macroeconomic background. We discuss the potential for strategic bidding behavior at the CDS settlement auctions.

Subject: Asset and liability management, Asset prices, Asset valuation, Bonds, Credit, Credit default swap, Currencies, Financial institutions, Money, Prices

Keywords: Asset prices, Asset valuation, Bonds, CDS buyer, CDS contract, CDS market, CDS seller, Credit, Credit default swap, Credit Default Swaps, Credit event, Default probability, Derivative Markets, Market signals, Settlement auction, WP

Publication Details

Pages:

32
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2014/239
Stock No:

WPIEA2014239
ISBN:

9781498389471
ISSN:

1018-5941

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