Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Overpricing of Emerging Market CDS?

A recent IMF working paper (Manmohan Singh and Jochen Andritzky
(2005), “Overpricing in Emerging Market Credit-Default-Swap Contracts:
Some Evidence from Recent Distress Cases”, IMF Working Paper 05/125)
claims that there is significant overpricing of Credit-Default-Swaps
on emerging market sovereigns.

The authors claim that the market prices CDS on
an assumed recovery assumption of 20%. Under this assumption, the CDS
spread can be used to compute an implied probability of default. The
authors then show that even during periods of financial distress and
restructuring (for example Argentina) the cash market price of the
distressed bonds (even the cheapest to deliver bond) is well above
20% of par (it is typically 40% of par). The authors then compute an
implied recovery rate from the cash market price of the cheapest to
deliver bond by assuming the implied probability of default
computed from the CDS spread under the 20% recovery assumption. They
then compute the theoretical CDS spread using the implied probability
of default from the CDS market and the implied recovery rate
assumption from the cash market. This theoretical CDS spread is below
the actual CDS spread.

It is difficult to understand what this whole exercise really
proves. Yes, it does show that emerging market sovereign CDSs should
not be priced under a 20% recovery assumption. Perhaps, it also shows
that there was a divergence between the CDS market and the cash market
— either the CDS was overpriced or the cash market was underpriced. To
arbitrage this difference away, it would be necessary to short the
cheapest to deliver bond in the cash market. This is where the
first author’s earlier paper (Manmohan Singh (2003) “Are Credit
Default Swap Spreads High in Emerging Markets? An Alternative
Methodology for Proxying Recovery Value”, IMF Working Paper 03/242)
throws some light. In that paper, Manmohan Singh explains that the
cheapest to deliver bonds were squeezed and were on special
repo. Moreover, the sovereign itself was trying to push up the price
of the cheapest to deliver bond by buying up as much of it as
possible. The price of the cheapest to deliver bond rose during
the period of distress. All this points to a very different conclusion
— that the cash bonds were overpriced. If so, it is not that the CDS spreads
were too high but that the cash bond yields were too low.

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