Working Paper No. 261
By Liz Dixon-Smith, Roman Goossens and Simon Hayes
We develop a simple bond pricing model to map the prices of individual EME sovereign bonds into term structures of implied (risk-neutral) default probabilities and expected recovery rates. Simple indices of bond spreads are found to be closely correlated with long-term risk neutral default probabilities, so may provide a straightforward way of monitoring shifts in investors’ perceptions. But short-term risk neutral default probabilities behave quite differently, implying that there are periods of market-wide changes in volatility that do not show in measures of average spreads. Estimation of time-varying recovery rates appears to work best for countries in crisis, and suggests that expected recovery falls as the prospect of default becomes imminent. Movements in the median time to default generally appear plausible, both across time and across countries.