Estimating Implied Default Probabilities and Recovery Values
from Sovereign Bond Prices

Abstract

This article develops a tractable framework to simultaneously estimate default probabilities and implied recovery values from sovereign bond prices. The model is simple and parsimonious yet allows for a term structure of default probabilities and provides an implicit recovery value. The latter is especially valuable in the context of sovereign credit risk where historical default rates are both rare and country specific. The model is applied to analyze the Greek debt crisis in 2010. In April and May, the probability of a Greek default quickly rose from 5% to 40%. After the €750 billion EU-wide rescue package is announced, the default probability instantaneously drops below 10%. The implied recovery value remains between 40 and 60 cents on the euro throughout this period.