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The paper has benefited by comments from Zhipeng Zhang, Jane Brauer, Ali Bastani, Darrell Duffie, Kenneth Singleton, and Ben Miller. The views expressed are solely of the authors and not of the IMF. Since this was issued as a Global Markets Monitor feature on February 10, 2009, the paper has also benefited from comments within the IMF.
The probability of default (i.e., the hazard rate) and the recovery value more or less offset each other when bonds trade near par. Such approximation works poorly when bonds trade at high spreads.
CDS spreads are usually more sensitive to changes to perceived default risk than the spreads on cash bonds, but in Lehman’s case, cash bond prices collapsed before CDS spreads rose. This produced the rather unusual scenario where the basis was positive during distress.
Washington Mutual was an exception and had a much higher recovery rate since it was acquired by JPMorgan Chase.
For ISDA’s deliverable bonds, please see: http://www.isda.org/companies/lehman/lehmandeliverableobs.html.
See the case of Brazil, Singh and Andritzky, “The Realities of Emerging Market CDS.”
To be clear, cash settlement only would apply as a standard term for widely traded reference entities. Those reference entities with low CDS notional, particularly relative to bonds outstanding, may continue to be physically settled. For example, although Washington Mutual, Inc. (holding company) CDS was largely cash settled, Washington Mutual Bank CDS was physically settled due to its significantly lower notional (parties were free to settle for cash bilaterally).
We refer to probability of default or distress in the broader context that includes conditional probabilities of default, joint probability of default, distance to distress, and joint default dependence (i.e., via the off-diagonal elements). In all such models, the general assumption has been to hold recovery value constant (in the range of 20–40).
Physical delivery is allowed within the context of ISDA protocol if it suits the CDS investor (see Ecuador box).