Friday, February 10, 2012

CDS pricing (hearsay

See also http://www.financial-risk-manager.com/risks/credit/edf.html

Use bid/ask from market to derive the insurer's (not insurance buyer's) cash flow including premium received and the "disaster" compensation amount[1]. This gives an implied hazard rate (or default density (?).

[1] related to recovery value. For physical settlement, the insurer pays the buyer the face value, i.e. the sum assured.

I was told this (implied) hazard rate is the key soft mkt data just like implied vol and implied yield. Calibration of hazard rates to CDS market quotes (spreads or upfront points with running coupons)

Plot the hazard rate along maturity. You get a credit spread curve (just like yield curve and the term structure of vol). I guess this is the term structure of hazard rate.

Using this curve you can price all other credit instruments.

Just like vol, there's a realized default rate (default intensity), whose value is very different from the implied hazard rates backed out from the market quotes.

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