How CDS Spreads Relate to Default Probability and Contract Coupons
Summary
A credit default swap spread is set by market trading and reflects participants’ views about both the reference entity’s likelihood of default and the recovery value of its debt after default. Because recovery assumptions affect the protection buyer’s expected loss, a spread alone does not determine a default probability; a recovery estimate is also needed to interpret it that way. The relationship becomes especially sensitive to recovery assumptions when spreads are wide.
The document also explains common CDS quoting and payment conventions. Contracts are generally quoted using a spread, but very wide spread names may instead be quoted with an upfront fee. A standard contract can pair that upfront payment with a fixed running coupon, commonly described as a standard percentage of notional; that coupon does not reset when the market spread changes after the trade begins. A less common constant-maturity CDS variant allows periodic protection payments to change with market spreads. These are general conventions, and the note does not provide a valuation formula or discuss variation across all contract terms and markets.
Key ideas
- CDS spreads are determined by market participants rather than by the reference entity’s issuer.
- A CDS spread reflects both default likelihood and assumed recovery value.
- A recovery assumption is needed to translate a spread into an implied default probability.
- Standard running coupons generally remain fixed over the contract’s life as market spreads move.
- Constant-maturity CDS contracts can adjust payments as market spreads change.
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Full text
# CDS credit spreads vs default probability
# CDS credit spreads vs default probability
What is the relationship between a CDS credit spread (as set by the CDS issuer) and the instantaneous default probability (as estimated by the CDS issuer)? I hear they are similar but not the same.
How are CDS's usually agreed: do they have a fixed coupon or does the coupon vary with credit spread? (If it varies, then how?)
thanks.
## Answer by Dimitri Vulis (score 2)
https://quant.stackexchange.com/a/43590
CDS spreads are set by the markets (the people who trade CDSs), not by the issuer of the reference obligation.
CDS spreads reflect the market participants' view of both probability of default and an assumption about the recovery - what the defaulted debt would be worth after the default. The recovery assumption grows more important as the CDS spread widens, and the perceived probability of default increases.
CDS spread is not the same as probability of default because one also needs a recovery assumption in order to convert between CDS spread and probability of default.
Usually CDS are quoted as a spread ("market standard quote"). When the spread is really wide, the "name" (credit, reference entity) is quoted as upfront fee instead. However standard CDS is traded with an upfront fee, and a running spread that is 100 bps (1% of the notional) for most names; when the MSQ is much wider than 100, running spread is sometimes 500 bps, or some other percentage of the notional.
The running spread does not change during the life of the CDS contract, even if the CDS spread in the market changes a lot since inception. However there is a very seldom traded variant of CDS called Constant-maturity CDS, where the protection payment for each period can change if the spread changes in the market.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.