Credit Default Swaps (CDS) and Credit Derivatives › Key Parameters

Each pricing parameter changes the CDS spread in a predictable way, helping you interpret market movements and manage positions.

The key parameters for CDS pricing are:

• Hazard Rate ($\lambda$): The instantaneous probability of default. Higher hazard rates increase default probability and thus the CDS spread. This is typically the most important driver of spread movements, as changes in perceived creditworthiness translate directly into hazard rate changes.
• Recovery Rate ($R$): The fraction of face value recovered upon default. Higher recovery rates reduce loss given default, lowering the CDS spread. Recovery rate uncertainty is often neglected in day-to-day trading but becomes critical during distressed situations.
• Risk-Free Rate ($r$): Used to discount future cash flows. Higher rates reduce the present value of both legs, though the net effect depends on the timing of default. In practice, the interest rate effect on CDS spreads is second-order compared to credit factors.
• Maturity ($T$): The duration of the contract. Longer maturities typically command higher spreads if the hazard rate is upward sloping, or simply accumulate more probability of default. The term structure of CDS spreads provides information about market expectations of how credit quality will evolve over time.
• Notional ($N$): The face amount of protection. It scales both the premium and protection payments but cancels out in the spread calculation, meaning the fair spread is independent of the notional amount.