CDS-implied PD and LGD

Our approach to estimating market-implied PD for sovereign exposures is based on the fact that CDS spreads accurately reflect the creditworthiness of the reference entity. The starting point in the methodology, originally developed for the Central Bank of Bosnia and Herzegovina, is a risk-neutral price of CDS, from which one can obtain a market-implied risk neutral probability of default. Due to the existence of different CDS maturities for single reference entity, it is possible to estimate the term structure of default probabilities with respect to maturities of corresponding CDS contracts. As a final result, PD can be computed by interpolating from the term structure for a given maturity date. The approach to estimating market-implied LGD is similar and based on the fact that both PD and LGD for a reference entity are incorporated in the price of a bond of that entity. From previously estimated CDS-implied PD, we back out the market-implied risk neutral LGD.