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| Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads by Jun Pan of the Massachusetts Institute of Technology, and November 28, 2006 Abstract: This paper explores in depth the nature of default arrival and recovery implicit in the term structures of sovereign CDS spreads. We argue that, in principle, a term structure of spreads reveals not only the parameters of the market-implied mean arrival rates of credit events (λQ), but also the implicit loss rates (LQ) given credit events. Applying our framework to Mexico, Turkey, and Korea, three countries with different geopolitical characteristics and credit ratings, we show that a single-factor model in which λQ follows a lognormal process captures most of the variation in the term structures of spreads. Our models imply highly persistent λQ under the pricing measure, and economically significant risk premiums associated with unpredictable future variation in λQ. We document significant correlations among these risk premiums and several economic measures of global event risk, financial market volatility and macroeconomic policy, both across maturities and countries. A potential role for (il)liquidity underlying the (small) mispricings of our model is explored along with the properties of the bid/ask spreads on the sovereign CDS contracts. Books Referenced in this Paper: (what is this?)
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