Credit Default Swap


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Credit Default Swap Valuation


FinPricing provides valuation models for the following credit products:

  • Credit Default Swap (CDS)
  • Step-up/Step-down CDS
  • Digital CDS
  • Cancellable CDS
  • Credit Default Swaption
  • CDS Option
  • CDS Bootstrapping (generating hazard rates)
  • CDS spread implied by price
  • Check FinPricing valuation models

1. Credit Default Swap Introduction

A credit default swap (CDS) is an OTC derivatives that is designed to protect one party from the loss on a specified face value of bond or loan at a credit event. The role of the other party is to provide this protection in exchange for preestablished payments.

A CDS is used to migirate the credit risk of an entity from one party to another. Two parties enter a CDS contract where the buyer makes periodic payments, known as the premium, to the other party until the maturity of the contract or a credit events.

A credit event can trigger the termination of a CDS. The event includes bankruptcy, restructuring, or failure to pay. Once a credit event occurs, the protection seller needs to pay a loss protection payment to the protection buyer.

A step-up or step-down CDS is a special type of CDS where the premium increases (step-up) or declines (step-down) during the life of the contract. The premium changes are typically on a fixed schedule. Sometimes, The premium changes are also accompanied by the notional changes.

A digital CDS, also called as fixed recovery CDS, is a special type of CDS where the protection payment is predetermined when a credit event occurs. The protection payment of a digital CDS is equal to the par multiplied by (1 - recovery), while the protection payment of a regular CDS is equal to the par minus the price of the cheapest to deliver asset of the reference entity.

A cancellable CDS gives the protection buyer the right but not the obligation to cancel the CDS at predefined dates. Once cancelled, the protection buyer stops to pay premium. Most commonly traded cancellable credit default swaps have multiple exercise dates. They are either American or Bermudan styles.

A credit default swaption or CDS option is a credit derivatives that gives its holder the right but not the obligation to enter into a credit default swap at predefined dates. CDS option can be European or Bermudan.


2. CDS Valuation

The CDS valuation is based on the reduced form model where the credit event time is the arrival time of the first jump of an inhomogeneous Poisson process.

Given the default intensity curve or hazard rate curve, one can derive the default probability and survival probability.

The protection buyer makes a series of payments to the protection seller. The value of the premium leg is the sum of those payments taking default/survial probabilities into account.

When a credit event occurs, the protection seller pays the protection buyer the face value of the entity minus the recovery value of the reference obligation. The value of the protection leg can be computed accordingly.

To price a CDS option or Cancellable CDS, one needs to use a numerical solution.