The Market Approach to CDS Pricing

The market approach to CDS pricing adopts the same no-arbitrage concept that is used in interest rate swap pricing. This states that, at inception  

The PV of the premium leg is straightforward to calculate, especially if there is no credit event during the life of the CDS. However the contingent leg is just that—contingent on occurrence of a credit event. Hence we need to determine the value of the premium leg at time of the credit event. This requires us to use default probabilities. We can use historical default rates to determine default probabilities, or back them out using market CDS prices. The latter approach is in fact implied probabilities. 

Let us consider first the probability of default. One way to obtain default probabilities is to observe credit spreads in the corporate bond market. 

Of these factors, one of the most significant is the term to maturity. The term structure of credit spreads exhibits a number of features. For instance, lower-quality credits trade at a wider spread than higher-quality credits, and longer-dated obligations normally have higher spreads than shorter-dated ones. For example, for a particular sector they may look like this  

An exception to this is at the very low end of the credit spectrum for example, we may observe the following yields for CCC-rated assets  

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