Why Long Credit Default Swap Exposure Can Rise Over Time
Summary
The document discusses the exposure profile of a buyer of credit protection in a single-name credit default swap. It explains the contract’s value as the protection leg minus the premium leg: as time passes, fewer premium payments remain, while the protection leg can become more valuable as the reference entity’s survival probability falls, assuming loss given default is held constant. This helps explain why the long-protection position’s positive value, and hence its exposure, may increase before a credit event.
The responses also distinguish the evolving value of the contract from its payoff when default occurs. At a credit event, the protection buyer receives a payment tied to notional less recovery, producing the maximum exposure in the described profile. One response interprets exposure as potential future exposure, but the document does not give a formal exposure definition, model assumptions beyond fixed loss given default, or numerical examples. The pattern is therefore a conceptual explanation, not a universal profile for all CDS contracts or exposure measures.
Key ideas
- A long-protection CDS is valued as the protection leg less the premium leg.
- The premium leg may decline in value as fewer scheduled payments remain.
- The protection leg can gain value as the reference entity’s survival probability falls, under the stated fixed-loss assumption.
- A credit event triggers the protection payment and can place the contract at its maximum exposure.
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Full text
# Credit exposure of a long CDS # Credit exposure of a long CDS According to Gregory, the exposure for. the long party of a credit default swap increases in its early years and then skyrockets when there is a credit event of the reference entity. I would have suspected the exposure starts off negative and then skyrockets when there is a credit event. Is this behaviour related to the theory that default probabilities increase with time? In case I misunderstood (I don't think I did), here is the source text > Consider the exposure profile of a single-name CDS as shown in Figure 8.20 (long CDS protection). The exposure increases in the early stages, which corresponds to scenarios in which the CDS premium (credit spread) will have widened. However, the maximum exposure on the CDS corresponds to the reference entity experiencing a credit event, which triggers an immediate payment of the notional less a recovery value ## Answer by Gordon (score 2, accepted) https://quant.stackexchange.com/a/20778 The value of a long protection CDS is the value of the protection leg minus the value of the premium leg. As time goes, the premium leg value decreases since the # of premium payments reduces. However, the protection leg value will increase because of the survival probability reduces while the LGD is held the same.The exposure, which is the positive port of the CDS value, will then increase. ## Answer by Thomas Maloney (score 0) https://quant.stackexchange.com/a/20784 First, one needs a definition of exposure. I believe in this case the author is referring to PFE. If you are long CDS, you are paying premiums to receive protection from default. When default occurs, you receive a payout, and the value of your CDS contract is at a maximum. By definition of PFE, the exposure is at a maximum.
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