This paper develops a framework to estimate implied recovery values and risk-neutral default probability term-structures from sovereign bond prices. The model is applied to Greek bonds during the European debt crisis of 2010. In April and May 2010, the probability of a Greek default quickly rises from 5% to 40%. On Monday 10 May 2010, after EU finance ministers, the ECB and the IMF agree on a EUR 750 billion EU-wide rescue package, the default probability drops instantaneously below 10%. The implied recovery value remains between 40 and 60 cents on the euro and does not get revised materially during this period.

With the recent debt crisis in Southern Europe, interest in the valuation of sovereign debt has revived. Although there is a large literature on the pricing and modeling of corporate debt, there has beencomparably little attention for sovereign credit risk in the academic literature. This paper aims to fill this gap and develops a framework to simultaneously extract implied recovery values and the risk-neutral term-structure of default probabilities from sovereign bond prices. The reduced-form model employs a binomial lattice framework where the price of a bond is the probability-weighted average of promised cash-flows (if the obligor survives) and the recovery value (if the obligor defaults). By imposing a flexible parametric structure on the term-structure of default probabilities, it is possible to simultaneously extract default probabilities and the recovery value using the cross-section of outstanding bonds. The framework improves existing reduced-form credit models in two directions. First, the model allows for a term-structure of default risk. Second, the model also provides implicit market assumptions about the recovery value, which is valuable given that sovereign defaults are both rare and country-specific. Recasting market prices into default probabilities and recovery values provides market professionals and policy makers with information that is better to interpret than plain bond prices.