Credit Default Swaps

This chapter shows how to price a credit default swap (CDS), the simplest synthetic credit instrument, using an intensity model. A credit default swap (CDS) is an insurance contract in which a credit protection buyer buys credit protection from a protection seller on a credit event of a reference entity on a contract specified notional amount. It develops two approaches to calibrate the model to observe market spreads. The standard process used for pricing purposes is outlined and a very practical issue behind calibration is discussed. Additionally, it shows a table comparing the recovery rates on some defaulted bonds during the credit crunch.