Financial Simulation Modeling in Excel

DETERMINING LOSS PROBABILITIES FROM BOND PRICES OR CREDIT DEFAULT SWAPS

Another frequent method of calculating default probability is by using market information. Two general markets can be used for these calculations: the credit default swap (CDS market) and the bond market. There is a third potential market, the bank loan market, but this market is generally considered to be less liquid and more difficult to obtain information on.

A credit default swap is a derivative contract based on whether or not a specified company will experience a credit event during a specified period. One party to the contract (a protection buyer) is paid if and only if the specified company experiences a credit event. In return for this contingent payment, the party agrees to make payments to the other party (a protection seller).

Entering into a CDS contract is often compared to buying or selling insurance on a corporate bond. If Brenda owns $1 million of IBM bonds and is worried about a default over the next five years, she may buy $1 million of protection through a CDS with Sam. In this case, Brenda will agree to pay Sam $50,000 (5 percent of $1 million) per year. In return, if IBM undergoes a credit event, Sam agrees to cover Brenda for any losses (the difference between $1 million and the recovery on the bond). When Brenda buys the protection on the bonds, she is effectively insuring the bond against any credit events. See Figure 5.6

FIGURE 5.6 A schematic of the relationship between a credit default ...