The Pricing Of Credit Default Swap

The rapid development and successful functioning of credit derivatives, among which the credit default swap (CDS) being the simplest, the most essential and the most fundamental one with the remainder being sub-derivatives from it, provided us with a timely solution to the management and regulation of the credit risks in China's commercial banks.Commonly used transaction mechanism of CDS features the regular periodic payments of a fee for the insurance of the credit risks by the buyer of the CDS to his counterparty so that once loss occurs owing to relevant asset credit events in the course of the contract, the trader effects the payment of the loss to the insured party. In this arrangement, the pricing of CDS needs to determine the swap premium. This pricing is based on the structure model and intensity model.Based on corporate value model, structure model describes default as explicit of corporate value worsening. Most typically, Merton model assumes that the company raised funds through equity and zero-coupon bonds. The equities function as European call that targets the issue firm value, with strike price being the principal of the bonds.Using structure model to price CDS, the text deduces the swap premium of the CDS, firstly with corporate liability as the reference assets under the Merton model ,and secondly with the corporate debt defaultable premature as the reference assets. It is assumed that the counterpart should have no default risk, and that the market should be free of arbitrage.Intensity model modelised default time which follow the exponential distribution, with the default intensity as the parameter. And probability of default is controlled by default intensity. The model assumed that the recovery rate of bonds should be constant, and default process and interest rate are independent of each other. JT model and JLT model are typical intensity modes. JT model assumed that the recovery rate is constant but JLT model assumed that the recovery rate is a function of time.Using the intensity model to price the CDS, the text firstly assumes that the counterparty should have no default risk, and that the market should be free of arbitrage, then determine the swap premium of the CDS with the reference assets defaultable between any two payment time and contingent claim paid at the default time.While structure model is not very effective in avoiding the influence of the sequence of debt payment over the price of CDS the intensity model can do the job. Structure model works to control the impact of default risk over contingent solvency while intensity model cannot. By combining the advantages of both models the pricing of CDS with default risks on the part of the counterparty can be achieved, using the structure model to determine the contingent payment value of the counterpart of the CDS in which the counterpart has default risk and default correlation exists between the reference creditor and the counterpart, at the same time , the intensity model determining the probability of the default time of the reference assets, and then determining the total protection fees paid by the protection buyer to the counterpart, and then determining the swap primium of the CDS with the couterpart of default risk under free-arbitrage market.