The IMF has published a working paper which looks at a number of technical issues when using credit default swap (CDS) data. The paper endorses the use of stochastic recovery in CDS models when estimating probability of default and suggests that stochastic recovery may be a better harbinger of distress signals than fixed recovery. Similarly, the paper notes that probabilities of default derived from CDS data are risk-neutral and may need to be adjusted when extrapolating to real world balance sheet and empirical data (e.g. estimating banks losses, etc).
Another technical issue discussed in the paper pertains to regressions trying to explain CDS spreads of sovereigns in peripheral Europe – the authors argue that the model specification should be cognisant of the under-collateralisation aspects in the overall OTC derivatives market. According to the authors, one of the biggest drivers of CDS spreads in the region has been the CVA teams of large banks that hedge their exposure stemming from derivative receivables due to non-posting of collateral by many sovereigns (and related entities).
The IMF has emphasised that the views expressed in this working paper are those of the authors and do not necessarily represent those of the IMF or IMF policy.