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Article

Credit Default Swaps: A Cash Flow Analysis

Terry Benzschawel and Alper Corlu
The Journal of Fixed Income Winter 2011, 20 (3) 40-55; DOI: https://doi.org/10.3905/jfi.2011.20.3.040
Terry Benzschawel
is a managing director at Citi Institutional Clients Group in New York City, NY.
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  • For correspondence: terry.l.benzschawel@citi.com
Alper Corlu
is an associate at Citi Institutional Clients Group in New York City, NY.
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  • For correspondence: alper.corlu@citi.com
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Abstract

Credit default swap (CDS) contracts are often considered synthetic versions of obligors’ bonds funded at LIBOR.Accordingly, in the absence of financial frictions and market segmentation, an obligor’s bond yield spread to LIBOR and its CDS premium at the same maturity should be zero.That analogy also underlies the consistent application of riskneutral pricing theory to both bonds and CDS.The authors describe difficulties in replicating a bond synthetically in the CDS, interest-rate swap, and repo markets and demonstrate that risk-neutral pricing theory implies different premiums for default protection on two bonds of the same maturity from the same obligor but having different coupons. They introduce a method for calculating CDS premiums and contingent payments under physical (i.e., actuarial) measure. The model derives physical probabilities from a combination of model-based estimates and historical values, and these are used to specify expected cash flows on CDS premium and default-contingent legs.The expected cash flows are then discounted at risk-free rates. The authors use this method to derive CDS premiums necessary to compensate for default and designate resulting excess market spreads as CDS risk premiums. They observe that, for certain historical periods, market CDS spreads were insufficient to compensate sellers of protection for expected payouts from default.

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The Journal of Fixed Income: 20 (3)
The Journal of Fixed Income
Vol. 20, Issue 3
Winter 2011
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Credit Default Swaps: A Cash Flow Analysis
Terry Benzschawel, Alper Corlu
The Journal of Fixed Income Dec 2010, 20 (3) 40-55; DOI: 10.3905/jfi.2011.20.3.040

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Credit Default Swaps: A Cash Flow Analysis
Terry Benzschawel, Alper Corlu
The Journal of Fixed Income Dec 2010, 20 (3) 40-55; DOI: 10.3905/jfi.2011.20.3.040
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  • Article
    • Abstract
    • CASH BOND EQUIVALENT OF CDS
    • THE STANDARD MODEL FOR CDS VALUATION
    • LIMITATIONS OF THE ASSET-SWAP MODEL OF CDS
    • ANALYSIS OF CDS CASH FLOWS
    • SUMMARY AND IMPLICATIONS
    • APPENDIX
    • ENDNOTES
    • REFERENCES
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