Explain the principles behind how the market prices CDS and the factors that affect that pricing
The idea
A CDS is priced so that the present value of the protection leg, the expected payouts on default, equals the present value of the premium leg, the expected coupon payments until default or maturity. Both depend on the hazard rate and the expected recovery rate. A useful approximation is spread ≈ hazard rate × (1 − recovery), so a 1.80% spread with 40% recovery implies a hazard of about 3%. Contracts pay a standard coupon, and the upfront payment ≈ (spread − coupon) × CDS duration × notional, paid by the buyer when the spread exceeds the coupon. After the trade, for the protection seller, value change ≈ minus (change in spread × duration × notional), and the sign reverses for the protection buyer, who gains when spreads widen.
In the app: 3 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Credit Default Swaps
- Explain credit default swaps (CDS), covering index CDS as well as single-name CDS, and the terms that specify a particular CDS contract
- Explain what counts as a credit event for CDS and how CDS contracts are settled
- Explain how CDS can be used to manage credit exposure and to take views on moves in the level or shape of the credit curve
- Explain how CDS can exploit mispricing between distinct markets, for example loans, bonds, equities and instruments linked to equity