The Credit Default Swap Risk Premium

Terry Benzschawel

This article was first published as a chapter in Credit Modelling (2nd edition), by Risk Books.

Chapter 5 presented methods for calculating the risk premiums and embedded leverage in corporate bonds. In this chapter, we will apply a similar analysis to the US corporate CDS market, and compare properties of CDS risk premiums and embedded leverage to those in the cash bond market. The plan of this chapter is to first present briefly the rationale for the approach, followed by the derivation of the CDS risk premium and a comparison of its properties with corporate bond risk premiums. This will be followed by a description of embedded leverage in the CDS market, along with a demonstration of the ability of ratios of current CDS risk premiums to one-year predicted default rates to predict one-year changes in the CDS risk premium.

THE CDS RISK PREMIUM

Since the rationale and procedure for computing market risk premiums in the corporate bond market is shown in Chapter 5, only a brief discussion of the general approach will be described herein. The main assumption of this approach to measuring risk premiums in the CDS market is that one can decompose the CDS premiums into compensation