Indifference pricing of credit default swaps in a multi-period model

Abstract

Credit default swaps (CDS) are the most common type of credit derivatives used for hedging and speculative purposes in credit markets. We consider a representative risk-averse investor who has initial endowment in credit instrument and invests in traditional financial instruments. Using the utility indifference pricing approach, we construct a pricing framework for single-name CDS contracts with periodic payments in a multi-period model. Moreover, we analyze CDS buyers with different trading motives, and examine the effect of risk aversion on the indifference upfront prices and credit spreads of CDS for investors with hedging or speculative motives. In particular, our results show that speculation in the CDS market provides a potential explanation for the formation of the negative CDS-bond bases during and after the global financial crisis.