How are Credit Default Swaps Priced

Credit default swaps (CDS) are a type of financial derivative that provide protection against the default of a particular debt instrument, such as a bond or loan. The price of a CDS is determined by the market, and is based on a variety of factors including creditworthiness, maturity, notional amount, prevailing interest rates and supply and demand.

via WSJ

Factors that Influence the price of a CDS

  1. The creditworthiness of the reference entity: The reference entity is the entity whose debt is being protected by the CDS. The higher the likelihood of the reference entity defaulting on its debt, the higher the price of the CDS will be.
  2. The maturity of the CDS: The longer the maturity of the CDS, the higher the price will be, since there is a greater chance that the reference entity may default over a longer period of time.
  3. The notional amount of the CDS: The notional amount is the amount of the debt instrument being protected by the CDS. The higher the notional amount, the higher the price of the CDS will be.
  4. The prevailing interest rates: Interest rates have an impact on the price of CDS, as they affect the cost of funding for the parties involved in the transaction.
  5. Supply and demand: Like any financial instrument, the price of CDS is also influenced by supply and demand. If there are more buyers than sellers, the price of the CDS will increase, and vice versa.

To calculate the price of a CDS, market participants use models such as the Black-Scholes model, which is commonly used to price options. The model takes into account the factors mentioned above, as well as assumptions about the volatility of the underlying debt instrument and other market variables.

It’s important to note that the pricing of CDS can be influenced by market sentiment and other factors that are difficult to predict. As a result, the actual price of a CDS may differ from the theoretical price calculated by a model.

Source: TC