Using Credit Derivatives to Compute Marketwide Default Probability Term Structures

Abstract

This article suggests a simple way of backing out marketwide risk-neutral default probability (and default density) distributions from quoted credit default swap (CDS) index spreads. It applies the approach to two marketwide European portfolios represented by two frequently traded iTraxx Europe CDS indexes, and the resulting analytical default probability term structures are updated on a daily basis. Such instantaneous default probability term structures should be useful not only for risk managers in commercial banks but also for hedge funds and others involved in speculation and arbitrage, as well as for supervisory authorities such as central banks in their quest for financial stability.