In: Finance
Suppose that the risk-free zero curve is flat at 6% per annum
with continuous compounding and that defaults can occur at times
0.25 years, 0.75 years, 1.25 years, and 1.75 years in a two-year
plain vanilla credit default swap with semiannual payments. Suppose
that the recovery rate is 20% and the unconditional probabilities
of default (as seen at time zero) are 1% at times 0.25 years and
0.75 years, and 1.5% at times 1.25 years and1.75 years. What is the
credit default swap spread?
What would the credit default spread be if the instrument were a
binary credit default swap?
The present value of the expected regular payments (payment rate is “s” per year), is
Time(yrs.) |
Probability of survival |
Expected Payment |
Discount Factor |
PV of Expected Payment |
0.5 |
0.99 |
0.495 s |
0.9704 |
0.4804 s |
1 |
0.98 |
0.49 s |
0.9418 |
0.4615 s |
1.5 |
0.965 |
0.4825 s |
0.9139 |
0.441 s |
2 |
0.95 |
0.475 s |
0.8869 |
0.4213 s |
Total |
1.8041 s |
The present value of the expected payoffs (notional principal =$1), is
Time(yrs.) |
Probability of default |
Recovery Rate |
Expected Payoff |
Discount Factor |
PV of Expected Payment |
0.01 |
0.2 |
0.008 |
0.9851 |
0.0079 |
|
0.01 |
0.2 |
0.008 |
0.956 |
0.0076 |
|
0.015 |
0.2 |
0.012 |
0.9277 |
0.0111 |
|
0.015 |
0.2 |
0.012 |
0.9003 |
0.0108 |
|
Total |
0.0375 |
The present value of accrual payments, is
Time(yrs.) |
Probability of default |
Expected Accrual Payment |
Discount Factor |
PV of Expected Payment |
0.25 |
0.01 |
0.0025s |
0.9851 |
0.0025 s |
0.75 |
0.01 |
0.0025 s |
0.956 |
0.0024 s |
1.25 |
0.015 |
0.00375 s |
0.9277 |
0.0035 s |
1.75 |
0.015 |
0.00375 s |
0.9003 |
0.0034 s |
Total |
0.0117 s |
The credit default swap spread sis given by:
1.804 s + 0.0117 s = 0.0375
It is 0.0206 or 206 basis points. For a binary credit default swap, we set the recovery rate equal to zero in the second table to get the present value of expected payoffs equal to 0.0468 so that
1.804 s + 0.0117 s = 0.0468
and the spread is 0.0258 or 258 basis points.