Value of Credit Default Swaps

Abstract

Credit Default Swaps are about to be introduced in India and this paper discusses the product and methods for valuation. A Credit Default Swap is a contract that provides insurance against the risk of a default of a particular company. The company is known as the reference entity and a default by the company is called a credit event. The buyer of the insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event occurs. The bond is known as the reference obligation and the total par value of the bond that can be sold is known as the swap's notional principal. The periodic payment (premium) by the protection buyer is typically expressed in annualised basis points of a transaction's notional amount. Hull Model and No Arbitrage Model are the two methods popularly used to arrive at CDS premium. Hull Model arrives at the spread from probable outflows from the contract and probable inflows from the contract. Estimation of probability of default is crucial in this model. No Arbitrage model replicates CDS cash flows in the cash market through buying/selling a bond, borrowing/lending in Corporate Repo market against the bond and entering into an Interest Rate Swap contract.