Pricing a CDS Contract

Given a set of default probabilities, we can calculate the fair premium for a CDS, which is the market approach first described in Chapter 1. To do this, consider a CDS as a series of contingent cash flows, the cash flows depending upon whether a credit event occurs. This is shown as FIGURE 10.17. The symbols are s is the CDS premium 

PVS is the expected present value of the stream of CDS premiums if there is no default 

PDc is the probability of default in period C R is the recovery rate and the other terms are as before. 

On the no-arbitrage principle, which is the same approach used to price interest rate swaps, for a CDS to be fairly priced, the expected value of the premium stream must equal the expected value of the default payment. 

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