Commercial Bank Credit Default Swap Pricing Theory Based On Credit Risk Management

Credit Default Swap (CDS), as the very basic and nuclear product of credit derivatives, is the foundation of credit derivatives market. CDS has a lot of advantages in credit risk managing, which offers new thought and technology for China’s commercial banks to manage credit risk positively. The financial crisis revealed the defects of the present CDS pricing mechanisms. Aiming at these defects, this paper developed some corresponding research.To begin with, the paper discussed the general pricing model of CDS basing on reduced form model. Taking defaultable bond as reference liability and under the assumption of mutual independence of default risk, market risk and recovery rate, established the CDS pricing model without considering counterparty risk.Then, the paper analyzed the negative correlation between recovery rate and default probability and established the negative correlating model. With the help of the relationship between default intensity and default probability, set up the CDS pricing model considering the negative correlation of these two variables. Analysis showed that the negative correlation magnifies the reference entity’s credit risk, making the CDS premium much higher. And the higher default risk is, the bigger this kind of influence is.Furthermore, this paper studied the CDS pricing model which considers the default contagion effect from counterparty. Default contagion from counterparty might bring tremendous loss to the market and even result in chain reaction of bankrupt. On the basis of Jarrow-Yu, the paper assumed that the protection seller’s default intensity would jump up after the reference entity’s default. As time goes, it will reduce gradually according to exponential function. After a period of time, its default intensity will only depend on common macroeconomic factors and its own financial situation. Utilizing the change of measure, the paper deduced the joint distribution and joint density function of two company’s default time, and then established the pricing model considering default contagion from counterparty. Analysis indicated that the higher the seller’s default intensity is, the lower the CDS premium is; the bigger default correlation between reference entity and seller, and the bigger the counterparty risk is, the smaller the premium is; the faster reducing speed of default contagion is, the lower counterparty risk is and the higher the premium is. Then this paper discussed how to involve the negative correlation between recovery rate and default probability in the CDS pricing process while considering the default contagion effect from counterparty.The last, this paper discussed the way of extracting default intensity from bond price, and provided the specific application process of CDS pricing model taking08Jinfa as reference liability, which is debenture bond. Then, the paper analyzed the credit risk that China’s commercial banks face with and the application of CDS in credit risk management. Aiming at the application of CDS, the paper came up with some suggestions developing China’s CDS market.