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

Abstract

This paper explores in depth the nature of the risk-neutral credit-event intensities (lambda^Q) that best describe the term structures of sovereign CDS spreads. We examine three distinct families of stochastic processes: the square-root, lognormal, and three-halves processes. These models employ different specifications of mean reversions and time-varying volatilities to fit both the distributions of spreads, and the variation over time in the shapes of the term structures of spreads. We find that these models imply very different risk-neutral probabilities that a sovereign issuer will survive over various future horizons. We also explore the use of the term structure of CDS spreads to separately identify both the loss rate in the event of default, L^Q, and the parameters of the process lambda^Q. Finally, we to attempt to shed some light on the magnitudes of default-event risk premia in sovereign markets.