Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 47. Credit Default Swaps Valuation

REN-RAW CHEN, PhD

Associate Professor, Rutgers University

FRANK J. FABOZZI, PhD, CFA

Professor in the Practice of Finance, Yale School of Management

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 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

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 many of the limitations of the traditional credit market instruments such as lack of availability of instruments with the required maturity or seniority. Increasing standardization and ...