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The realities of emerging market CDS

As restructuring rather than default becomes the norm for credit events in the emerging markets, it is time for those involved in the market to reappraise the effects of distressed situations on credit default swap prices, argue Manmohan Singh and Jochen Andritzky

RECOVERY VALUES ON sovereign emerging market debt have not been subject to extensive research, largely owing to the changing nature of sovereign debt crises. Since bond prices depend on the expected recovery value, it is possible to derive recovery values implied by market prices, especially during a crisis.

Spreads on credit default swap contracts can be used to estimate the implied default probabilities using the cheapest-to-deliver (CTD) bond as a proxy for a stochastic recovery value. A CDS works as an insurance policy against the risk of an underlying borrower defaulting. Typically, an investor who owns a regular bond buys a CDS and makes fixed regular payments to the protection seller (the insurer). In exchange, the insurer guarantees payment of the whole amount (par value of the bond) upon default or a credit event (as specified in the contract).

A CDS contract usually refers to a basket of deliverable bonds at the time of the contract, giving the protection seller a valuable option to deliver the cheapest bond upon default or a credit event. These CTD bonds – or deliverable bonds – are generally priced at a discount to other similar bonds owing to their illiquidity, currency denomination, legal jurisdiction, and other special features.

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