Non-linear Gaussian sovereign CDS pricing models

Abstract

Prior literature indicates that quadratic models and the Black-Karasinki model are very promising for CDS pricing. This paper extends these models and the Black (1995) model for pricing sovereign CDS' s. For all ten sovereigns in the sample quadratic models best …t CDS spreads insample, and a four factor quadratic model can account for the joint e¤ects on CDS spreads of default risk, default loss risk and liquidity risk with no restriction to factors correlation. Liquidity risk appears to a¤ect sovereign CDS spreads. However quadratic models tend to over-…t some CDS maturities at the expense of other maturities, while the BK model is particularly immune from this tendency. The Black model seems preferable because its out-of-sample performance in the time series dimension is the best.