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Structured Credit Products: Credit Derivatives and Synthetic Securitisation, 2nd Edition by Moorad Choudhry

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CHAPTER 7

Credit Default Swap Pricing

In this chapter, we concentrate specifically on the credit default swap (CDS) and a market approach for pricing this instrument. We consider the plain vanilla structure, in which a protection buyer pays a regular premium to a protection seller, up to the maturity date of the CDS, unless a credit event triggers termination of the CDS and a contingent payment from the protection seller to the protection buyer. If such a triggering event occurs, the protection buyer only pays a remaining fee for accrued protection from the last premium payment up the time of the credit event. The settlement of the CDS then follows a pre-specified procedure, which was discussed in Chapter 2.

THEORETICAL PRICING APPROACH

A credit default swap, like an interest rate swap, consists of two legs, one corresponding to the premium payments and the other to the contingent default payment. The present value (PV) of a default swap can be viewed as the algebraic sum of the present values of its two legs. The market premium is similar to an interest rate swap in that the premium makes the current aggregate PV equal to zero. That is, for a par interest rate swap, the theoretical net present value of the two legs must equal zero; the same principle applies for the two cash flow legs of a CDS.

The cash flows of a CDS are illustrated in Figure 7.1 on page 252.

FIGURE 7.1 Illustration of cash flows in a credit default swap.

Normally, the default payment on a CDS will be (1 ...

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