Insurance against a default by a particular company on a particular issuance of debt. It involves periodic pmt by the party purchasing the ins and, in the event of default, a pmt by the seller
Reference entity: entity whose credit rating is being protected
Reference obligation: bond used to monitor wheter a credit event occurs and to determine swap payoff
Notional principal: par value of the reference obligation
Credit event: default (could be default of other obligations)
CDS Spread definition and mathematical approach
CDS Spread = pmt rate such that PV(buyer) = PV(seller)
Step 1: determine unconditional default probability
Step 2: determine buyer's pmts (annual spread and accrual pmt when default occurs)
Step 3: determine seller's pmt
Step 4: solve for spread, s
2 Credit Indices examples
CDX NA IG and iTraxx EuropeBoth are PF of 125 investment grade
Cash vs Synthetic CDO
Objective of CDO is largely to transfer credit risk → no need to contain actual bonds (only credit default swaps). In that case we call it a synthetic CDO