Components of CDS Pricing:
1. Premiums (Spread):
– Fixed Premium: The protection buyer pays a fixed premium periodically (usually quarterly or annually) to the protection seller throughout the life of the CDS contract.
– Spread over Libor: This premium is typically quoted as a spread over a benchmark rate like the London Interbank Offered Rate (Libor). The spread reflects the perceived credit risk of the reference entity.
Credit Spread Curve:
– The credit spread curve represents the relationship between the CDS spreads and the time to maturity of the contract. Longer maturities generally have higher spreads due to increased uncertainty and risk over time.
Probability of Default:
– CDS pricing incorporates the probability of default (PD) of the reference entity over the contract’s life. This is derived from credit rating agencies, market perceptions, and historical default data.
Recovery Rate:
– The recovery rate is the percentage of the principal amount recovered by the protection buyer in case of a credit event (default) by the reference entity. It influences the payout amount upon default.
Risk-free Rate:
– The risk-free rate is used to discount future cash flows associated with the CDS contract to their present value. It accounts for the time value of money and alternative investment opportunities.
Valuation of CDS:
1. Present Value of Premium Payments:
– The present value of the fixed premium payments made by the protection buyer to the protection seller over the contract’s life.
2. Expected Losses:
– The expected losses are calculated based on the probability of default and the anticipated recovery rate. It represents the potential payout amount the protection seller may have to make in case of default.
3. Mark-to-Market Adjustments:
– CDS contracts are marked-to-market periodically, reflecting changes in the creditworthiness of the reference entity and market conditions. Changes in credit spreads and interest rates affect the contract’s value.
4. Counterparty Risk:
– The valuation also considers counterparty risk, i.e., the risk that the protection seller may default on its obligations. Creditworthiness and collateral agreements influence this assessment.
Factors Influencing CDS Pricing:
– Credit Quality: Higher credit risk of the reference entity leads to higher CDS spreads.
– Market Sentiment: Market perceptions and investor confidence impact CDS pricing.
– Economic Conditions: Macroeconomic factors such as GDP growth, interest rates, and industry trends affect credit risk and CDS pricing.
– Regulatory Environment: Changes in regulatory requirements and market reforms can influence pricing and market liquidity.
The pricing and valuation of Credit Default Swaps (CDS) involve assessing credit risk, expected losses, recovery rates, and market conditions. This process helps investors and institutions manage and transfer credit risk exposure effectively through financial derivatives.
