Sovereign Recovery Schemes: Discounting and Risk Management Issues

Abstract

We consider some pricing and risk management issues related to defaultable bonds, in the context of sovereign debt default and restructuring. Standard recovery schemes such as fractional recovery of market value, of Treasury and of face value are investigated: we discuss their consistency with market practice both from a pricing and a risk management perspective. We also pay attention to the tradable basic instruments such as defaultable discount bonds or coupon and principal strips that are the building blocks of traded level coupon bonds. Modelfree pricing formulas are provided and the use of a hypothetical default-free yield curve is challenged. We show that the fractional recovery of par involves two discount curves, one for principal payments and one for coupon payments, a departure from standard bootstrapping and pricing engines. In a second step, this pricing framework can be specialized along the modelling lines routinely used in credit derivatives markets. In light of collective action clauses applicable to the issuance of new bonds in the eurozone and the pricing characteristics of strips, we investigate some practical issues on bond and credit derivatives markets: stripping of bonds in distressed periods, implied market recovery scheme and consistent recovery rates. JEL Classification: G01, G12, G33

Inside the EMs Risky Spreads and CDS-Sovereign Bonds Basis

“…On one hand, in that way, we are consistent with the HJM methodology of Schönbucher [12] for a single risky curve under RMV and produce parsimonious no-arbitrage conditions for the extension to a multi-curve environment. On the other hand, as pointed out in Bonnaud et al [5], for bonds denominated in a different currency than the numerator employed in discounting, the RMV assumption should be the working engine. Their argument is exactly as ours above, in case of default, the sovereign would rather dilute by depreciating the exchange rate and thus the remaining cash flows of the bond produce in essence the RMV structure.…”

“…What it should be depends on our purposes. On one hand, if we would like to just extract the credit and currency spreads from the yield curves and calibrate a reduced form model, 5 it would be convenient to employ the setting from Sect. 2.…”