A previous version of this paper was circulated as "Jumps and Recovery Rates Inferred from Corporate CDS Premia". We are thankful to FIRM@WU for access to their high-performance computing resources as well as friendly support, and to Dow Jones for providing us with complete ICB sector information.
AbstractUsing an extensive cross-section of US corporate CDS this paper offers an economic understanding of implied loss given default (LGD) and jumps in default risk. We formulate and underpin empirical stylized facts about CDS spreads, which are then reproduced in our affine intensity-based jump-diffusion model. Implied LGD is well identified, with obligors possessing substantial tangible assets expected to recover more. Sudden increases in the default risk of investment-grade obligors are higher relative to speculative grade. The probability of structural migration to default is low for investment-grade and heavily regulated obligors because investors fear distress rather through rare but devastating events.
The paper introduces a Black&Cox-type structural model for credit default swaps. The existing literature on structural CDS pricing is extended by allowing a general functional form for the default barrier specified without reference to asset volatilities, dividend yields and interest rates. We develop a fast and robust algorithm to compute survival probabilities numerically. An empirical application suggests that the market-implied barrier is stable over time, with a possibly hump-shaped term structure. The implied barrier can be used for computing survival probabilities consistent with objective expectations of asset evolution, for pricing under counterparty risk, and for determining optimal corporate bond covenants.
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