Credit Risk Modeling Using Excel and VBA with DVD

10

Credit Default Swaps and Risk-Neutral Default Probabilities

In this chapter, we discuss the most important instrument on the credit derivatives market: the credit default swap (CDS). A CDS is a bilateral contract that provides an insurance against the default of a particular issuer, known as the reference entity. The protection seller, who is short in the CDS (and thus long risk in the underlying), insures the protection buyer, who is long in the CDS, in the following way: in the case of a predefined credit event, the protection buyer has the right to sell bonds of the defaulted issuer to the protection seller – at their face value. The total volume covered by a CDS is called its notional principal. For single-name CDS, which we consider in this chapter, the credit event is the default of the issuer.

Of course, this insurance does not come for free. The buyer makes periodic payments (typically at the end of each quarter, half-year or year for which the insurance is bought) to the seller until the maturity of the CDS or the default. Upon default, settlement can take place either by physical delivery or in cash, depending on the terms agreed on in the contract. Physical delivery means that the buyer hands the bonds to the seller, who then pays their par value to the buyer. If cash settlement is specified in the contract, the protection seller pays the difference between the bonds' par value and some suitably defined market price.

Let us illustrate the structure of the CDS with ...