Credit derivatives default probabilities

An interesting development in the credit default swap market is the response of protection sellers to credit events, the impact is ultimately reflected in the price of credit default swaps, as reflected by the credit default swap spread. Credit derivative markets have experienced spread widening at times of bad credit related news, in effect this reflects the protection sellers pricing the risk of the additional probability of a credit event into the protection they sell. 

For credit derivative contracts in which the payout is on credit events other than default, the modeling of the credit evolutionary path is critical. If, however, a credit derivative contract does not payout on intermediate stages between the current state and default then the important factor is the probability of default from the current state. 

Various credit derivatives may be priced using this model for example, credit default swaps, total return swaps, and credit spread options. The pricing of these products requires the generation of the appropriate credit dependent cash flows at each node on a lattice of possible outcomes. The fair value may be determined by discounting the probability-weighted cash flows. The probability of the outcomes would be determined by reference to the risk neutral transition matrix. 

In practice, the spread information from the CDS market is used to imply the probability of default and the hazard rate for the underlying reference entity. The recovery rate is an input when the calculation of implied probabilities takes place. It is common to assume a recovery rate that reflects the rate on the cheapest to deliver deliverable obligation. Credit derivative traders will monitor the prices of the cheapest to deliver bonds (i.e., deliverable obligations with the lowest recovery), when constructing hedges. 

This section examines a few commercially available software packages and analytic tools designed to mitigate risk in the increasingly innovative credit derivative market. It reviews CDS data providers, examines analytic programs designed to provide expected default probabilities and theoretical prices, and highlights applications intended to simplify CDO investments. ... 

We will now turn our attention to sophisticated risk management tools. These tools are critical for companies involved in the credit derivative market. The following products are designed to produce default probabilities, the fundamental building block for effective risk management. 

The NX CR Engine is a pricing and risk management tool that allows users to model a wide range of credit derivative products. It produces theoretical prices for single-name credit default swaps, baskets and CDOs. In addition, NumeriX s software produces survival probabilities, recovery rates and correlations. 

Robert Jarrow and Stuart Turnbull, Pricing Derivatives on Financial Securities Subject to Default Risk, Journal of Finance 50, no. 1 (1995), pp. 53-86. Kamakura Risk Information Services Credit Risk Overview Kamakura s Press Release, Kamakura Launches Basel II Default Probability Service and Announces First Client, October 31, 2002. 

Credit-derivative pricing is similar to the pricing of other off-balance-sheet products, such as equity, currency, and bond derivatives. The main difference is that the latter can be priced and hedged with reference to the underlying asset, and credit derivatives cannot. The pricing model for credit products incorporates statistical data concerning the likelihood of default, the probability of payout, and market level of risk tolerance. 

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