Market Expectations and Default Risk Premium in Credit Default Swap Prices

Abstract

We study expectations of credit market and default risk premium implicit in credit default swap prices in the case of Argentine default. We find that the default risk premium is substantial and its relation with default probability is not monotone. Default risk premium increases with rising default probability when default probability is low, but it declines when default probability reaches a certain level. This result suggests that default risk premium plays a primary role in the pricing of credit derivatives when default risk is moderate, but its impact declines when default risk becomes extremely high. We also find that the default risk premium in Argentine sovereign debt has an upward-sloping term structure throughout the sample period. Our results show that variation in default risk premiums in Argentine sovereign debt was affected by changes in the U.S. business cycle and credit conditions and the overall strength of the Argentine economy.