Credit Default Swaps 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 for a reference obligation or reference issuer. 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 flawed, but fortunately there exist superior models that can be used in pricing these instruments. Keywords: contractual spread; credit default swap (CDS); credit event; default probability; default swap; default swap basis; mark-to-market value; par asset swap spread; Poisson process; static replication; survival probability