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.

Posted at 2:05 pm IST on Mon, 11 Jul 2005         permanent link

Categories: derivatives, sovereign risk

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