Default and Recovery Implicit in the Term Structure of Sovereign "CDS" Spreads

This paper explores the nature of default arrival and recovery implicit in the term structures of sovereign "CDS" spreads. We argue that term structures of spreads reveal not only the arrival rates of credit events <formula format="inline"><file name="jofi_1399_mu1.gif" type="gif" /></formula>, but also the loss rates given credit events. Applying our framework to Mexico, Turkey, and Korea, we show that a single-factor model with <formula format="inline"><file name="jofi_1399_mu2.gif" type="gif" /></formula> following a lognormal process captures most of the variation in the term structures of spreads. The risk premiums associated with unpredictable variation in <formula format="inline"><file name="jofi_1399_mu3.gif" type="gif" /></formula> are found to be economically significant and co-vary importantly with several economic measures of global event risk, financial market volatility, and macroeconomic policy. Copyright (c) 2008 The American Finance Association.