Sovereign default probabilities online -
Extracting implied default probabilities from CDS spreads
Global Risk Analysis
Basics of credit default swaps
Protection buyer (e.g. a bank)
purchases insurance against the
event of default (of a reference
security or loan that the protection Credit default swap
buyer holds) Pr otection
Premium
No payment
s eller Pr otection buyer
No credit event
Agrees with protection seller (e.g. an (investor)
Credit event
Payment
investor) to pay a premium
Repayment
Interest
Credit
In the event of default, the protection
seller has to compensate the Refer ence
bor r ow er
protection buyer for the loss
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What are CDS spreads?
Definition: CDS spread = Premium paid by protection buyer to the seller
Quotation: In basis points per annum of the contract’s notional amount
Payment: Quarterly
Example: A CDS spread of 339 bp for five-year Italian debt means that
default insurance for a notional amount of EUR 1 m costs EUR 33,900
per annum; this premium is paid quarterly (i.e. EUR 8,475 per quarter)
Note: Concept of CDS spread (insurance premium in % of notional)
≠ Concept of yield spread (yield differential of a bond over a “risk-free”
equivalent, usually US Treasury yield or German Bund yield)
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How do CDS spreads relate to the probability of default?
The simple case
For simplicity, consider a 1-year CDS contract and assume that the total
premium is paid up front
Let S: CDS spread (premium), p: default probability, R: recovery rate
The protection buyer has the following expected payment: S
His expected pay-off is (1-R)p
When two parties enter a CDS trade, S is set so that the value of the
swap transaction is zero, i.e.
S=(1-R)p
S/(1-R)=p
Example: If the recovery rate is 40%, a spread of 200 bp would translate
into an implied probability of default of 3.3%.
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How do CDS spreads relate to the probability of default?
The real world case
Consider now the case where
Maturity = N years
Premium is paid in fractions di (for quarterly payments di =0.25)
Cash flows are discounted with a discount factor from the U.S. zero
curve D(ti)
For convenience, let
q=1-p
denote the survival probability of the reference credit with a time profile
q(ti), i=1…N
Assume that there is no counterparty risk
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Valuation of a CDS contract in the real world case
For the protection buyer, the value of
the swap transaction is equal to
Expected PV of contingent payments
(in the case of default)
- Expected PV of fixed payments
_______________________________
= Value for protection buyer
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Computation of the fixed and variable leg
With proper discounting and some basic probability math, you get
N N di
PV[fixed p ayments] = ∑ D(ti )q(ti)Sdi + ∑ D(ti){q(ti − 1 ) − q(ti)}S (1)
=
i 1 =1
2
i
Discounted premium payments if no defaul t occurs Accrued premium payments if de fault occurs between payments dates
N
PV [contingent payments] = (1 − R )
∑ D(t )
i =1
i {q(ti − 1) − q(ti )}
( 2)
Compensati on payment Prob. of default in respect. period
Note that the two parties enter the CDS trade if the value of the
swap transaction is set to zero, i.e. (1)=(2)
7
Sovereign default probabilities online
DB Research provides a web-based tool to translate CDS spreads
into implied default probabilities
Access Sovereign default probabilities online
8 Contact: Kevin Körner, +49 69 910-31718
