Aurora Borealis
1 July 2014 CFA Institute Journal Review

Extraction of Implied Default Probabilities and Expected Recovery Values from a Combination of Bond Prices and CDS Spreads (Digest Summary)

  1. Marvin Powell, CFA

The combination of implied default probabilities and expected recoveries serves as the foundation of credit risk. The author provides techniques to observe the default probabilities and recovery rates implied by both bond prices and credit default swap prices. Specifically, he provides a methodology that differs from existing conventions of assuming a constant recovery rate.

What’s Inside?

Using data available from the markets for bonds and credit default swaps (CDS), the author creates a framework to extract implied default probabilities and expected recoveries. He is able to decompose the combined nature of credit risk into its various components. The application of CDS in combination with the bond market allows implied default probabilities to be disentangled from expected recoveries for different maturities. Although the existing literature assumes a constant recovery rate across the entire sample of maturities, the perceived riskiness of the issuer can differ among maturities.

How Is This Research Useful to Practitioners?

The author proposes his framework as a way to extract the implied default probabilities as well as the expected recovery values for different maturities. Default probabilities and expected recoveries represent valuable tools that can have many useful applications for academics and practitioners. This methodology can be used to compare default probabilities and recovery values implied by market prices with historical ratings–based default and recovery rates.

The implied default probabilities and expected recovery rates obtained for entities with data available on both bonds and CDS can be further applied to borrowers with similar characteristics but for which one of the two markets does not exist, has sparse data points, or lacks sufficient liquidity. Furthermore, the extracted term structure of implied default probabilities and the term structure of expected recovery values can be used to search for common credit risk factors and macroeconomic variables that cause changes in bond prices and CDS spreads in the cross section of borrowers. It can also be used to identify noticeable differences in the reactions of bond prices or CDS spreads to financial events.

The degree of comovement among implied default probabilities, as well as expected recovery rates across the maturity spectrum for a single borrower or for a cross section of borrowers in the same industry or in the same credit-rating class, can be investigated. The influence of a broad array of macroeconomic factors on the dynamics of risk-neutral default probabilities and corresponding recoveries can also be examined.

How Did the Author Conduct This Research?

The author uses a reduced-form model to perform the research. A reduced-form model is based on the premise of the existence of a risk-neutral probability measure and the absence of arbitrage opportunities. In reduced-form models, a default is treated as a random stopping time with a stochastic arrival intensity. Moreover, the author uses a type of reduced-form model that estimates risk-neutral probabilities from a given set of market prices.

Numerous assumptions, the first being that defaults occur only on a bond’s coupon date, are used. Another of the author’s assumptions is that each coupon payment has a cross-default provision with every subsequent coupon payment as well as the principal, implying that the initial default triggers default for all remaining payment dates. A third assumption is that all bonds issued by the same entity but with different maturities default as soon as one such bond defaults because of a cross-default provision.

The author’s framework of modeling the implied default probabilities and the expected recoveries relaxes the assumption that recovery rates are static over time. That is, the expected recovery at Time 1 can be different from the expected recovery at Time 2. The model’s resulting outputs are based on the observed market inputs. In other words, the risk-neutral default probabilities and the corresponding recovery values are functions of bond yields, coupon rates, CDS spreads, and risk-free rates.

Abstractor’s Viewpoint

The author provides great insight into the various credit risk characteristics of bond markets and CDS markets. Having a detailed understanding of each of these markets, as well as how the two can be used together, allows for increased asset management performance. It is critical for investment professionals to have a thorough understanding of these credit dynamics to maximize the performance of the portfolio. Ultimately, further research should expand on these findings to improve professionals’ comprehension of how the implicit default rates and recoveries behave through economic cycles.

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