What is calculating “breakeven” CDS spread and valuing existing CDS?

Expert Solution

The credit default swap (CDS) is a popular financial derivative contract, to transfer the credit risk (default risk) from one party to another. In a typical CDS derivative contract one party sales credit protection to the next party, to bear any type of financial loss on book value of protected asset class in case of unfavorable incidence.

The current value or mark-to-market (MTM) of an existing CDS derivative contract is the payment linked with the derivative contract holder would pay or receive to close his obligation.

Simply , Mark to market Value (MTM) value of CDS can be found out with

MTM = Current Market Value of Remaining time for Protection – Expected Present Value of 4-year Premium Leg at given interest rate

As per Professor Hull [2009], the break-even CDS spread is the annual cost for protection in contradiction of a default by the reference entity. The model determine the break even CDS spread(S) at a point the sum of the PV [expected payoffs] is equal to the sum of PV[expected regular plus accrual payments] for 1 to year N.

Mathematically it can derived to,

=default probability,

r= Risk free rate

R= Rate of recovery

jeff jeffy answered 4 months ago

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