Encyclopedia of Financial Models, 3 Volume Set

Credit Default Swap Valuation

REN-RAW CHEN, PhD

Professor of Finance, Graduate School of Business, Fordham University

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

DOMINIC O’KANE, PhD

Affiliated Professor of Finance, EDHEC Business School, Nice, France

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.

Credit default swaps (CDSs), or simply default swaps, provide an efficient credit-risk transferring financial instrument. Their over-the-counter nature also makes them infinitely customizable, thereby overcoming ...