Jarrow Paper Available at Kamakura Web Site
Kamakura Corporation reported Thursday that it is releasing an important new research paper by Managing Director for Research Prof. Robert A. Jarrow entitled “Problems with Using CDS to Infer Default Probabilities.” The popular financial press frequently quotes default probabilities for a specific firm on the basis of a credit default swap spread that may be based solely on dealer indications, not traded prices. Leaving the issue of illiquidity aside and using an analogy to life insurance, Professor Jarrow shows that frequently used formulas for converting credit default swap spreads to implied default probabilities are riddled with errors and therefore highly inaccurate.
Professor Jarrow begins the paper by showing that life insurance economics and credit default swap economics are essentially identical. Professor Jarrow states in the paper “It seems absurd to…use life insurance premiums to infer the mortality probabilities,” because the mortality probabilities can be directly calculated using actuarial science. Professor Jarrow goes on to say the following:
“Surprisingly, when discussing corporate or sovereign default probabilities, the common belief is almost the reverse. For some unknown reason, it is believed that implied default probabilities from CDS spreads provide reliable estimates. This paper shows that this common belief regarding implied default probabilities is false.”
Martin Zorn, chief administrative officer for Kamakura Corporation, said Thursday, “Professor Jarrow’s research on this topic is extremely timely, given moves by financial services regulators to remove references to legacy credit ratings in their rules and regulations. Professor Jarrow shows clearly that, even if one assumes the CDS market is liquid and competitive, the derivation of accurate empirical default probabilities from credit default swaps is an extremely difficult task that has not yet been mastered within academic finance. Moving the settlement of credit default swaps to an exchange may improve transparency but does not resolve the fundamental problem that Professor Jarrow clearly points out in his paper. Using statistical measures of default probabilities like those in the Kamakura Risk Information Services is the only accurate alternative to ratings and credit default swaps.”
Kamakura Risk Information Services has been the leading multiple models default probability service since public firm default probabilities were launched in November 2002. The public firm default probability service currently covers 31,000 firms in 37 countries. The KRIS sovereign default probability service was launched in 2008, and the non-public firm service was announced in 2011.
