Credit Default Swap Valuation

Abstract

Credit default swaps are the most popular of all the credit derivative contracts traded. Their purpose is to provide financial protection against losses incurred following a credit event of a corporate or sovereign reference entity. Replication arguments attempting to link credit default swaps to the price of the underlying credits are generally used by the market as a first estimate for determining the price at which a credit default swap should trade. The replication argument, however, is dependent on the existence of same maturity and same seniority floating rate bonds. Even if such securities do exist, contractual differences between CDS and bonds can weaken the replication relationship. Over the past decade, the increased liquidity of the CDS market has meant that in some cases, it, and not the bond market, is the place where credit price discovery occurs. Despite this it still necessary to have a CDS valuation model for the valuation and risk-management of existing positions. Keywords: Credit default swaps (CDSs); credit event; Wall Street Journal; Financial Times; 1999 ISDA Credit Derivative Definitions; default swap; par asset swap spread; default swap basis; default probabilities; survival probability; mark-to-market; Credit derivatives explained; Lehman Brothers Fixed Income Research; Explaining the basis: Cash versus default swaps; Lehman Brothers