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Trading the differences in expectations between the CDS and bond markets
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This paper uses the framework developed by Vrugt (2010) to extract the recovery rate
and term-structure of risk-neutral default probabilities implied in the cross-section of
Portuguese sovereign bonds outstanding between March and August 2011. During this
period the expectations on the recovery rate remain firmly anchored around 50 percent
while the instantaneous default probability increases steadily from 6 to above 30
percent. These parameters are then used to calculate the fair-value of a 5-year and 10-
year CDS contract. A credit-risk-neutral strategy is developed from the difference
between the market price of a CDS of the same tenors and the fair-value calculated,
yielding a sharpe ratio of 3.2
Descrição
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European soverign debt crisis Soverign credit risk CDS arbitraging