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Credit Default Swaps:
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TERRY BENZSCHAWEL
is a managing director at Citi
Institutional Clients Group
in New York City, NY.
terry.l.benzschawel@citi.com
ALPER CORLU
is an associate at Citi Insti-
tutional Clients Group
in New York City, NY.
alper.corlu@citi.com
40 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
10:21 AM Page 40
A Cash Flow Analysis
TERRY BENZSCHAWEL AND ALPER CORLU
credit default swap (CDS) contract
A is an agreement to exchange a spec-
ified set of coupon payments in
return for the right to receive the
par face value of a reference obligation after the
particular obligor undergoes a credit event.
The parties involved in the contract are a pro-
tection buyer, who pays the coupons or premiums
(usually quarterly), and a protection seller, who
receives the premiums, but must pay the buyer
the par value of an eligible security in exchange
for that security in the event of a default, bank-
ruptcy, or restructuring.1
In more recent versions of the standard
CDS contract, the protection buyer makes an
upfront payment set by the seller and pays a
standard running 100 bp or 500 bp premium
that depends on the riskiness of the reference
obligor. (Even for the new contract, the upfront
cash flow and fixed spread premium can be
converted to an effective spread premium).
The CDS contract is usually obligor-specific,
referring to either a corporate or sovereign
entity. The securities that are eligible for
delivery to the protection seller in event of
default, the reference obligations, are typically from
a single class of debt (unsecured bonds, loans,
or subordinated bonds, etc.), but can be asset
specific.
For most purposes, both the CDS contract
with upfront payment and standard coupon and
that with no upfront payment and market-based
coupons can be represented using the diagram
in Exhibit 1. The exhibit shows an example of
a CDS written on $10 million of notional with
reference to firm XYZ. The buyer of protec-
tion makes quarterly payments, the premium leg,
for as long as there is no credit event or until
the maturity of the contract, whichever comes
first. The CDS premium, even if trading with
constant coupon and upfront fee, is often
expressed as an annual amount in basis points.
Also, contracts from a given firm are commonly
issued at a number of standard maturities, with
the most common term being five years. The
protection seller agrees to pay the buyer the
face value of the CDS contract if XYZ under-
goes a credit event and the buyer of protection
delivers to the seller the defaulted security or
its cash equivalent.2
The advantages of having a liquid credit
default swap market are well known. Prior to
the development of the CDS market, investors
had few options for hedging existing credit
exposures or entering a short credit position.
In such cases, investors would have to borrow
bonds in an over-the-counter market, being
subject to poor liquidity and high financing
costs. In addition, typical fixed-rate corporate
bonds have huge exposure to interest-rate
movements, which is often undesirable for
investors wishing to make pure credit plays.
The relatively tight bid–ask spreads of CDS
contracts and, in particular, CDS index prod-
ucts have provided extremely efficient means
for investors to express views on credits of
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EXHIBIT 1
Representation of a Typical CDS Contract Prior to April 2009
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Notes: The protection buyer makes regular coupon payments to the protection seller and the contingent exchange of a reference obligation in exchange for payment
of its face value in case of a credit event. More recent contracts have an upfront cash payment to the seller of protection and either a 100 bp or 500 bp running
coupon but can still be represented as in the exhibit.
firms and countries around the world. Furthermore, the
CDS contract has provided the building block for other,
more complicated partitioning of credit exposure via such
synthetic products as single-tranche CDOs (S-CDOs),
whereby investors can express a view on credit correla-
tion with specific risk profiles, and options on CDS,
whereby investors take positions on credit spread volatility.
Despite the wide success of CDS contracts as finan-
cial instruments, recent turmoil in the credit markets have
exposed vulnerabilities in the CDS market. For example,
the lack of a central clearinghouse for CDS trades has
revealed systemic and firm-specific weaknesses in the
ability to effectively manage counterparty risk. In addi-
tion, conventions for trading CDS have enabled trading
practices that, by enabling investors to go short with little
or no initial investment, have contributed to the unprece-
dented volatility in cash and synthetic credit markets since
mid-2007. Furthermore, pressure from buyers of protec-
tion via CDS has been blamed for contributing directly,
at least in part, to the failure of some firms. Although CDS
have been widely criticized for their role in the current
credit crisis, an aspect of the CDS market that has been
largely unrecognized or overlooked is that current methods
for pricing and hedging CDS may be inadequate and/or
problematic. For example, we question some assumptions
that underlie the widespread application of risk-neutral
pricing theory to CDS; one of which implies that firms’
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CDS are synthetic bonds with implicit funding at LIBOR.
To that end, we examine the CDS as asset-swap model
and its potential limitations. In addition, we suggest a
pricing method based on analyses of specified and expected
CDS cash flows that, combined with estimates of phys-
ical default probabilities and recovery values, provides an
alternative perspective for evaluating CDS risk and rela-
tive value.
CASH BOND EQUIVALENT OF CDS
It is nearly axiomatic among CDS investors that a
CDS contract can be replicated by long and short posi-
tions in cash bonds by the seller and buyer of protection,
respectively, who can borrow the reference obligation in
the repo market (Kumar and Mithal [2001] and Kakodkar
et al. [2006]).3 That is, the no-arbitrage argument of the rela-
tionship between credit default swaps and corporate bonds
states that one can replicate the premium leg of the CDS
with a long position in the reference obligation combined
with a fixed-for-floating interest-rate swap and the payout
leg with a short position in the reference bond and a repo
agreement to borrow that security. For example, Exhibit 2
shows the cash flows for each leg of the CDS contract in
Exhibit 1 represented as an asset-swap. Clearly, replicating
each leg of the CDS contract involves several operations
by both buyer and seller of protection. The no-arbitrage
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EXHIBIT 2
No-Arbitrage Model for CDS Where the Buyer of Protection Is Long a Bond Financed at LIBOR along with an
Interest-Rate Swap and the Protection Seller Is Short the Reference Obligation and Has Borrowed the Bond via Repo
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Note: This representation assumes that all parties can finance all transactions at LIBOR and that there is no cost to the protection seller to repo the reference asset.
model is widely, if only implicitly, assumed by most market
participants. The asset-swap and CDS equivalence is
reflected in the Z-spread,4 the common measure of adjusting
cash bond spreads for comparison with CDS premiums, and
by methods for estimating the cash–CDS basis as the spread
to the interest-rate swap curve (Choudhry [2006]). Given
the general acceptance of the no-arbitrage argument
between cash bonds and CDS and because we argue that
this argument has limitations, we consider in detail the no-
arbitrage model from the perspectives of both buyers and
sellers of protection.
The Protection Buyer
A depiction of a five-year CDS contract as an asset-
swap between the buyer and seller of protection appears
in Exhibit 2. Consider first the protection buyer who agrees
to make regular premium payments to the protection seller
as long as there is no credit event or until the maturity of
the CDS, whichever comes first. To replicate this with a
cash bond, the buyer of protection must purchase a five-
year bond issued by the reference obligor. For this example,
42 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
assume that the bond is a fixed-rate instrument purchased
at par. To pay for the security, the protection buyer bor-
rows the par amount times the notional from a bank, call
it bank 1, at LIBOR.5 The coupons from the borrowed
bond are used for two purposes. First, the obligor enters
into a five-year fixed-for-floating rate swap to generate
three-month LIBOR to make quarterly interest payments
on the loan for the bond. The remainder of the coupon,
the amount above the five-year swap rate, is paid out as a
premium to the protection seller. The fact that the buyer
of the bond must finance the transaction at a rate assumed
to be LIBOR is the reason that the cash versus CDS basis
is referenced to the bond’s Z-spread.
As long as the bond pays coupons to the buyer of
protection, the buyer can finance the bond and pass the
spread premium to the protection seller. If there are no
credit events prior to maturity of the CDS and the ref-
erence bond, the interest-rate swap expires and the
bond’s obligor pays the face value to the protection
buyer, which is used to repay bank 1 for the initial loan.
However, if the reference obligor triggers a credit event
prior to CDS maturity, the buyer of protection is due
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the face value of the bond times the notional from the
protection seller. The protection buyer can use the payoff
to deposit in bank 2 earning LIBOR and use the
LIBOR proceeds to enter into a floating for fixed-rate
swap until the remaining maturity of the initial five-
year swap. This way, at the maturity of both interest-rate
swap contracts, the net payout will be zero and the buyer
of protection withdraws the deposit in bank 2 and uses
the proceeds to repay the principal on the original loan
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from bank 1.
Finally, it should be noted that the demonstration of
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the no-arbitrage model of the cash bond versus CDS rela-
tion is not unique. One could devise other combinations
of bond purchases and sales, borrowing arrangements,
interest-rate swap agreements, and repurchase agreements
to equate cash bonds and CDS. The importance of the pre-
sent demonstration is that all of these mechanisms involve
transactions in markets whose price determinants may
differ from those of the deliverable obligations, giving rise
to non-credit-related influences on both bond spreads
and CDS premiums. Furthermore, these factors may affect
one side of the buyer/seller relationship and not the other.
The Protection Seller
Consider now the CDS as asset-swap from the per-
spective of the seller of protection as depicted in the right-
hand side of Exhibit 2. Recall that the protection seller
receives quarterly payments from the protection buyer
unless there is a credit event before the maturity of the
CDS. If a credit event is triggered prior to maturity, how-
ever, the protection seller must pay the protection buyer
the face value of the reference obligation times the notional
of the CDS contract. To replicate the payout profile of
the protection seller in the cash bond market, one can sell
short the reference security, deposit the sale proceeds in
a bank at LIBOR, and enter into a fixed-for-floating swap.
The fixed leg of the swap is combined with the premium
from the protection buyer to pay the coupon on the bor-
rowed security. As for the protection buyer, the model
assumes that the seller of protection can borrow and lend
at LIBOR and that none of the securities trade as special
in the repo market.
Assume now that the reference obligor triggers a credit
event prior to maturity. The protection seller receives the ref-
erence security in exchange for the face value of the secu-
rity times the notional. The seller makes that payment from
funds deposited in the bank at inception. The reference
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security is then delivered to the counterparty in the orig-
inal short sale by the protection seller and the borrowed
bond is returned as the repo is unwound whereby the seller
of protection pays the lender the loss on the borrowed bond
(i.e., face value minus recovery). Finally, the fixed-for-floating
rate swap is offset by a floating–for–fixed swap for the
remaining time to maturity.
The CDS–Cash Bond Basis
The previous example is used to explain why, in an
arbitrage-free setting, the break-even CDS premium
should be identical to the asset-swap spread on a bond
priced at par. Because of this, when investors wish to com-
pare market risk premiums between CDS and their ref-
erence bonds, they often use the Z-spread, which is a
spread to the LIBOR curve.6 Despite their assumed the-
oretical equivalence, Z-spreads on cash bonds and their
corresponding default swap spreads are rarely the same, and
the difference between them is called the basis. For example,
Exhibit 3 shows the CDS minus cash bond basis for firms
in the North American investment-grade CDS index
(CDX.NA.IG)7 from December 2005 through April
2009. From the inception of the CDX index in 2003, the
basis had typically been 10 bps–20 bps positive (CDX
premium greater than the average of its constituent’s bond
Z-spreads), but since 2006, the basis has largely been neg-
ative, with average bond spreads exceeding CDX.NA.IG
premiums by as much as 250 bps.
Given the complexity of the relationship between
a firm’s reference bond and its CDS, as demonstrated in
Exhibit 3, it is not surprising that the basis between cash
bonds and CDS is rarely zero. In fact, there are a variety
of market factors, technical details, and implementation
frictions that underlie the basis. Some of the well-known
factors that influence the basis are as follows:
• Method of calculating the basis (e.g., Z-spread,
I-spread, C-spread)
• Imbalances between market demand for buying and
selling protection
• Differences in liquidity premiums for a firm’s cash
and synthetic assets
• Impact of “cheapest to deliver” cash asset
• Funding versus LIBOR
• Cash reference assets trading away from par value
• Difference in conventions for accrued interest on
bonds and CDS premiums
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EXHIBIT 3
Historical CDS vs. Cash Bond Basis for Firms in the North American Investment-Grade CDS Index,
December 2005–May 2009
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Source: Citi and Markit Partners.
• Counterparty risk exposure
• Risk from different definitions of “default” for cash
and synthetic assets
• Choice of calculation conventions for the basis and
hedge ratios
• Bonds trading tight to LIBOR (such as AAA rated
bonds) have non-negative CDS premiums
Details of the factors underlying the cash versus CDS
basis are described in detail elsewhere (Kumar and Mithal
[2001], Choudhry [2006], Kakodkar et al. [2006], King
and Sandigursky [2007], and Elizalde et al. [2009]), so are
not discussed further in this article. We list these factors
only to illustrate the large number of factors that influ-
ence the CDS–cash basis. The contributions to the basis
from the various sources that include funding rates, swap
spreads, and the repo market provide limitations to the
utility of the “no-arbitrage” argument as applied to credit
default swaps and their cash bond asset-swaps. That is,
unambiguously distinguishing the effects of all the fac-
tors contributing to the current basis is extremely diffi-
cult. Furthermore, hedging all the factors identified as
underlying the basis, even if known, is also difficult given
the available market instruments. Finally, as we describe
in detail in the following sections, there are other serious
objections to the no-arbitrage explanation for the spread
relationship between CDS and their cash asset referents.
These are discussed after the introduction of the standard
method for valuing CDS in the risk-neutral setting.
44 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
THE STANDARD MODEL
FOR CDS VALUATION
The standard framework for interpreting CDS values
and risk management is the reduced-form model. In prac-
tice, the reduced-form model takes as input the market
CDS premium and U.S. Treasury rates and solves, in a
risk-neutral setting, for the default probability that results
in equal expected present values of premium and con-
tingent legs. A popular version of that model has been
proposed by Hull and White [2000] based on the reduced-
form approach of Duffie and Singleton [1999] and a
detailed description appears in O’Kane and Turnbull
[2003]. In the reduced-form approach the credit event
process is modeled in continuous time as a hazard rate
that represents the instantaneous probability of the firm
defaulting at a particular time. Within the risk-neutral
setting, the present value of a security is the expected
value of its cash flows discounted at the risk-free rate. For
example, let the time of default be denoted as τ and assume
that RV is a random amount recovered if default occurs
before the end of the period, T (i.e.,τ ≤ T ). Then, a risky
zero-coupon security can be viewed as a combination of
two securities: one that pays $1 at time T if the issuer does
not default and one that pays RV if default occurs before
or at maturity. This can be expressed in terms of the risk-
neutral expectations (E 0Q ) as:
 − T rdt   − τ rdt 
v 0 = E 0Q e ∫0 1(τ >T )  + E 0Q e ∫0 RV(τ ≤T )  (1)
   
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Within this framework, it has proved con- EXHIBIT 4

venient to model default events using a Poisson Representation of the Contingent Leg of a Credit Default Swap
counting process as introduced by Jarrow and in the Risk-Neutral Setting
Turnbull [1995] where the cumulative risk-neu-
tral probability of default in the interval from 0 to
t is given by

Q
  t Q

CPD = 1 − E exp  − ∫ λudu 
t 0 (2)
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  0  
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where λ is the instantaneous jump to default or

default intensity. For any given interval from t – 1 to
t, the probability of default by time t conditional on
survival up to time t – 1 can be obtained as follows:

CPDtQ − CPDtQ−1
pQt ,t −1 = t −1 (3)
∏ i =1
(1 − pQi ,i−1 )

Because the default probabilities in Equa-

tions (2)–(3) are derived in the risk-neutral set-
ting, their values can be inferred from market prices
of CDS contracts. As noted before, a CDS contract
has two cash flow streams—a premium leg and a
In the risk-neutral pricing framework, the CDS
contingent leg. The premium leg consists of quarterly fixed
spread at the initiation of the contract is assumed to reflect
payments made by the protection buyer to the seller until
equal present values of the premium and the contingent
maturity or until a credit event occurs, whichever is first.
legs. Because the protection buyer makes the quarterly
On the contingent leg, the protection seller makes a single
payments of amount c/4 (where c is the annualized pre-
payment dependent on the occurrence of a credit event,
mium or CDS spread) conditional on the survival of the
usually default. Although the contingent payment is the
reference entity with probability 1 – CPDQ, the present
face value of the reference bond, the protection buyer must
value of the premium leg equals
deliver the reference security or its equivalent value to the
protection seller. Thus, the amount of contingent payment 4T
cT
can be modeled as the face amount multiplied by (1 – RV), PVpremium = ∑ dt ∗ (1 − CPDtQ ) ∗ (4)
where RV is the recovery rate immediate after default, t =1 4
expressed as percentage of the face.
The pattern of potential contingent leg payouts of where dt denotes the risk-free discount factor from t = 0
a CDS is represented in Exhibit 4. On each time step in to t quarters and T is the maturity of the CDS in years.
the exhibit, a credit event occurs with probability pt,t–1 or On the contingent leg, the protection seller makes a pay-
survives with probability 1 – pt,t–1. As described previ- ment 1 – RV only if a credit event has occurred in a par-
ously, if the firm defaults, the seller pays an amount whose ticular time interval with probability CPDtQ − CPDtQ−1.
value is the equivalent of the face minus the recovery Hence the present value of the contingent leg is calcu-
value, 1 – RV in Exhibit 4, and the contract terminates. lated as follows:
Otherwise, the firm survives until the next period in which
it again either defaults or survives. The exhibit illustrates 4T

how marginal default and survival probabilities accumu- PVcontingent = ∑ dt ∗ (CPDtQ − CPDtQ−1 ) ∗ (1 − RV ) (5)
t =1
late over time up until default or maturity.

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EXHIBIT 5
Cumulative Risk-Neutral Probabilities of Default by Maturity for Various Credit Rating Categories, March 19, 2010
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Source: Citi and Markit Partners.
Finally, setting these two present values equal we
arrive at the following expression for the CDS premium:
4 ∗ ∑ t4=T1 dt * (CPDtQ − CPDtQ−1 ) *(1 − RV )
cT =
∑ 4t =T1 dt * (1− CPDtQ )
Much of the modeling effort regarding CDS involves
determining the term structure of firms’ cumulative risk-
neutral default rates over the life of the contract. Using
Equation (6) and an assumed fraction of face value recov-
ered in default, we can determine the values of cumula-
tive default rates, CPDtQ , at each node in the lattice in
Exhibit 4. For example, assume that we have as input a
firm’s market derived CDS spreads for a range of matu-
rities, e.g., c (T = 0.5), c(T = 1.0 ), ..., c (T = 10). The cum-
ulative risk-neutral probability of defaults, CPDtQ , can then
be obtained from this CDS term structure using a boot-
strapping procedure: We first extract CPD0Q.5 using c(0.5)
and then obtain CPD1Q using c(1) and CPDQ0.5 obtained in
the first step. The process continues until we obtain CPDtQ
for all maturities in the CDS term structure.
46 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
Exhibit 5 shows average cumulative risk-neutral
default probabilities for March 19, 2010, for credit ratings
from AAA to CCC. Risk-neutral default probabilities
increase monotonically with maturity for all rating classes.
(6)
As expected, the risk-neutral default probabilities are sig-
nificantly higher as credit quality decreases, being lowest
for AAA securities and highest for CCC averages.
LIMITATIONS OF THE
ASSET-SWAP MODEL OF CDS
The traditional no-arbitrage model of the CDS as an
asset-swap has proved useful for understanding the relation-
ship between bonds and CDS and has aided the develop-
ment of the CDS market. However, large displacements in
cash and CDS markets and the 300 bp fluctuation in the
CDS versus cash bond basis for investment-grade credits in
recent years have highlighted limitations of that interpretive
framework. There are other concerns as well. These include:
• potential profit or losses from interest-rate swap posi-
tions on an asset-swap in the event of default that
would not occur with a CDS;
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• failure to account for the cost of risk on the mark-
to-market of positions in the replicating portfolio
arising from changes in swap and repo rates as well
as changes in either party’s credit risk;
• differences in the price of protection for holders of
different bonds issued by the same obligor but priced
in the market at different relationships to par;
• consistent positive CDS premiums for AAA rated
credits, which almost always trade at premiums to
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LIBOR, are inconsistent with the asset-swap analogy
of CDS.
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Profitability of Asset-Swaps
in a CDS Replicating Portfolio
Consider first the mark-to-market sensitivities of a
buyer and seller of protection that enter into each side of
an asset-swap replication of a CDS contract as depicted
in Exhibit 2. For such investors, the structure of the repli-
cating trade will allow them to meet their contractual
payoffs as if each were involved in a CDS trade. However,
investors in the replicating long- and short-CDS portfo-
lios will have additional exposures, even assuming that the
reference bond is trading at par and each side is able to
borrow at LIBOR. For example, the buyer and seller of
protection will be exposed to movements in swap rates
from the swap contract. For example, if swap rates rise, all from the same issuer whose indicative information appears
else equal, the buyer of protection will have unrealized
profit on the swap position that it has obtained at a pre-
viously lower rate and the seller will have a mark-to-
market loss. This is not an immediate issue for either
investor, aside from potential credit exposure and/or
margin calls, because the protection buyer must continue
to fund the LIBOR swap from the fixed bond proceeds
and the seller of protection will continue to receive the
increased LIBOR from their bank. Another problem
results from the fact that changes in the CDS contract
may not mirror those of the underlying bonds. That is, E X H I B I T 6
the investor in an asset-swap is exposed to the CDS Indicative Data for Three Five-Year Senior Unsecured
versus cash basis. As shown in Exhibit 3, changes in the Bonds at Par, Discount, and Premium Prices Relative to Par
basis can be large and have moved as much as several
hundred basis points over several months.
Consider also what happens if the bond issuer in
an asset-swap defaults. The seller of protection must
deliver the notional times the par face value of the ref-
erence obligation to the protection buyer in return for
the reference security. The protection seller passes the
reference security to the counterparty to which it has
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sold the bond short and terminates the repo (or arranges
a reverse repo).8 Assume that, prior to default, swap rates
have increased. Presumably, the price of the fixed-rate
borrowed bond will have decreased from par value due
to an overall rise in rates that is independent of its credit
quality. This has a couple of effects. First, the borrower of
the bond is now paying a higher rate than LIBOR on the
face value of the bond at its current market price. That
is, a new buyer would have to make a lower absolute pay-
ment to fund that same bond at that lower price. Fur-
thermore, an investor wishing to enter into a CDS contract
on that bond will have to buy protection on less than full
face value of the bond. Under those circumstances, one
might expect the CDS price to change as marginal buyers
of protection for bonds bought at less than par, whose
coupon spread to LIBOR remains that of the original
buyer, will require less total protection since the CDS
contract is written on par face value, as demonstrated in
the following section.
Failure of the Law of One CDS Price
Another issue with the CDS as asset-swap analogy
is that the value of credit protection on a single obligor
will differ for investors of its bonds with different coupons
at the same maturity. For example, consider three bonds
in Exhibit 6. Assume that Bond 1 is a five-year bond issued
today at par with a coupon of 7%, approximately equal
to the yield of a BBB rated bond on June 15, 2009. Now
consider another bond, Bond 2, originally issued with a
15-year maturity exactly 10 years ago by the same issuer
as Bond 1. At the time Bond 2 was issued, the obligor
was a much better credit and was able to issue the bond
at par with a coupon of 3.4%. However, now that the
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obligor is BBB rated, investors are demanding a 7% yield
and Bond 2 is trading at a discounted price of 85. Finally,
consider a third bond issued five years ago at par, when
borrowing by B rated credits required a coupon of 10.6%.
At the current coupon rate of 7%, that bond is now trading
at 115.
The risk-neutral cumulative probability of default,
CPDtQ , at any maturity for this obligor can be calculated
from the obligor’s par yield curve and the U.S. Treasury
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yield curve. For example, to find the risk-neutral default
probability for the 0.5-year par bond, CPD0Q.5, we assume a
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recovery value (in this case 40% of principal) and solve for
the CPDQ0.5 that equates the cash flows from the 0.5-year par
bond to the value of 100 when discounted by the corre-
sponding Treasury yield. This process is repeated at regular
intervals over the life of the bond in question. The resulting
CPDtQ curve for the BBB rated par bonds on June 15, 2009,
appears in Exhibit 7.
Within the CDS as asset-swap model, we can use the
Q
values for CPDt at various maturities in Exhibit 7 to cal-
culate the expected premium of a credit default swap via
Equation (6). The value for the premium obtained using
U.S. Treasury discount curves is 414 bp per annum. We
can approximate this premium as a yield spread to LIBOR
by subtracting the difference between LIBOR and Trea-
sury spot rates on June 15, 2009, a difference of 48 bps.
Thus, our estimate of a five-year CDS premium for this
BBB obligor is roughly 366 bps.
Now consider Bond 2, the discount bond issued by
the same obligor as Bond 1. As mentioned, Bond 2 was
EXHIBIT 7
Risk-Neutral Default Probabilities as a Function
of Maturity Implied by BBB Bonds and U.S. Treasury
Par Yield Curves, June 15, 2009
48 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
issued 10 years ago as a 15-year bond at 3.4% and now
has 5 years to maturity. Assume that we bought Bond 2
on June 15, 2009, at 85, a price well below the par value
of Bond 1. Since both Bond 1 and Bond 2, while trading
at 100 and 85, respectively, will have a 40% recovery of
face value in default, we might require less default pro-
tection if we owned Bond 2 than if we owned Bond 1.
Since CDS are quoted in units of 100 points of face value,
the need for less protection on Bond 2 should translate
into fewer CDS contracts for a given notional amount of
bonds than for Bond 1 (or an equal number of contracts
at a lower spread premium).
We determine the necessary premium on a CDS for
default protection on 100 face of Bond 2. Let N2 be the
notional amount of protection that we need to buy to neu-
tralize the default risk of Bond 2. To break even in default,
the buyer of Bond 2 will need to get 45 points per 100 face
(i.e., 85 – 40) from the protection seller. In terms of CDS
contract, this should be equal to N2 * (1 – RV/100). Thus,
equating these two values, we have
 RV 
85 − 40 = N 2 ∗  1 − (7)
 100 
and therefore N2 = 75. Because Bonds 1 and 2 are from
the same obligor, we can solve for the premium, c, using
the same risk-neutral default probabilities and recovery
rate that we used for Bond 1. The resulting value of c is
275 bps per annum.
In fact, a simple way to determine the CDS pre-
mium adjustment required for a bond trading away from
par is to realize that the relative premium between a par
and non-par bond from the same firm is directly pro-
portional to their losses in default. That is, for the example
of Bonds 1 and 2,
c non-par 85 − RV 45
c par = 100 − RV ⇒ c non-par = 60 × c par = 275 bp (8)
CDS contracts are quoted in units of 100 face regard-
less of the prices of bonds eligible for delivery in default,
so what is the correct “fair” price of a CDS protection
on an obligor having issued Bonds 1 and 2? Clearly, analysis
based on the risk-neutral credit curve would suggest two
different prices for CDS protection per 100 notional of
Bonds 1 and 2; 366 bps per annum on Bond 1 and
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 JFI-BENZSCHAWEL:Layout 1 12/10/10 10:21 AM Page 49
275 bps per annum on Bond 2. Similarly, for Bond 3 from
this same obligor, having a 10.6% coupon and trading at
115 for 100 notional, our analysis suggests that the price
of CDS protection necessary to recover the price in default
is 458 bps.
One implication of the foregoing analysis is that, for
a firm having bonds with different market prices relative
to par, the cost of protecting one’s original principal can
vary significantly, thereby providing potential arbitrage
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opportunities. For example, consider three investors, A, B,
and C, where A owns 100 face of Bond 1 in Exhibit 6,
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B owns 100 face of Bond 2, and C owns 100 face of
Bond 3. Investor A will pay $100 for Bond 1, whereas
investor B pays only $85 for Bond 2 and investor C pays
$115 for Bond 3, assuming that the bonds all trade at
equivalent cash flow yields.9 Suppose each investor buys
protection on their respective investments to cover poten-
tial losses from default and, based on the risk-neutral
default curve in Exhibit 7, assume that the cost of CDS
protection on 100 face is 3.66% per annum. Now, con-
sider expected returns from two different hedging sce-
narios involving investors A, B, and C.
Case 1: Investors A, B, and C each buy CDS on 100
units of face and pay $3.66 a year until maturity or
default.
Case 2: Investor A again purchases protection of 100
units of face at $3.66. However, investor B now buys
CDS protection on only 75% of the outstanding
face of the bond purchased at $85.10 In default, B will
EXHIBIT 8
Returns from Investing in Hypothetical BBB Rated Par and Non-Par Bonds for CDS Protection
Bought for Full Face Value of Bonds or Adjusted for Loss Given Default
Note: The average cumulative five-year default rate for a BBB rated credit is roughly 1.4%.
WINTER 2011
receive $75 from the CDS contract and the recovery
value of $40 on the excess 25 points of face not
delivered into the contract (i.e., $10), thereby recov-
ering their investment. Investor C, having paid $115
for 100 face of bond, buys 125 units of CDS pro-
tection to cover potential loss of investment from
default. That is, in default, investor C will receive
$125 from the CDS contract but must deliver an
additional 25 units of face at a recovery value of $40
into the CDS contract at a cost of $10.
In each scenario, we assume a constant default rate
of 0.28% (i.e., the annual historical rate for a BBB credit)
over the five-year contract term. Exhibit 8 displays the
internal rates of return (IRRs) for investors A, B, and C
under two different default scenarios for each of the two
hedging scenarios. The first row in Exhibit 8 shows that
investor A has an expected IRR of 3.4% under average
default conditions but a return of only 1.7% if default
occurs within the first six months. Consider for com-
parison the returns for investor B. In Case 1, buying pro-
tection on 100 face of CDS, IRRs under historical default
rates for investors A and B are similar. The 0.3% advan-
tage for investor A in Case 1 results from the larger
coupon on the par bond and occurs despite the 15-point
advantage in cases of default for investor B. However,
this advantage for investor A will only result on average.
That is, as shown in the far right column of Exhibit 8,
if the issuer defaults in the first six months, investor B will
have windfall gains of 39%, owing to the 15 points of
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 JFI-BENZSCHAWEL:Layout 1 12/10/10 10:21 AM Page 50
excess return on the 100 face of CDS protection.
Exhibit 8 displays IRRs for investor C in Case 1 that
are the reverse of those for investor B. That is, for average
default scenarios, investor C performs slightly better than
investor A (and B), but for early default, investor C suf-
fers a huge loss of 22% on the initial $115 investment.
In Case 2, investor B buys CDS protection on only
75% of the outstanding face. Investor B’s annual premium
payments therefore will be only $2.75 per unit face per
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annum per unit of bond face owned. In this case, the
expected IRR for investor B increases to 4.1%, exceeding
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investor A’s IRR of 3.4%. The advantage in expected
returns to investor B under historical default rates results
from a combination of relatively low default rates and the
“pull-to-par” at maturity under conditions of no default.
However, should a default occur in the first six months,
B’s IRR will be only 0.4%, because B, while having his
investment protected, receives little benefit from the pull
to par at maturity. The expected IRR for investor C in
Case 2, owner of the premium bond, is lowest at 2.9%,
owing to the large premium required for 125 points of
CDS protection. However, for an early default, investor
C has a greater IRR than investor A and investor B in Case
2.
The foregoing analysis has several implications for
investors in bonds and CDS. First, it is clear that the
risk–reward aspects of CDS protection will differ for
investors in par and non-par securities from the same issuer.
In fact, it is not clear which hedging strategy is best for non-
par securities as each has its advantages and disadvantages.
Buying and hedging discount bonds appears to be the best
overall strategy, whereas investing in premium bonds has
EXHIBIT 9
Example of Quarterly Cash Flows from Premium Leg (left-hand panel) and Contingent Leg (right-hand panel)
Note: L is the Loss Given Default of a Hypothetical One-Year CDS Contract (cash flows not drawn to scale).
50 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
the greatest downside risk. More importantly, however,
these examples reveal clear limitations of the CDS as asset-
swap analogy as a general framework for relating bond
prices to CDS spreads.
ANALYSIS OF CDS CASH FLOWS
Given the limitations of the CDS as asset-swap
framework described in the previous section, we introduce
a simplified approach to evaluating CDS contracts and
explore its usefulness for interpreting market data on CDS
spreads. In the proposed cash flow framework, we value
the premium and contingent legs as sums of the discounted
values of their expected cash flows under physical mea-
sure. For example, Exhibit 9 displays expected cash flows
from premium and contingent legs of a hypothetical one-
year CDS contract. The values of cpdi are expected cumu-
lative probabilities of actual defaults from time t = 0 to
t = i.11 Notice that the size of the premium payments
shown on the left-hand side in Exhibit 9 decreases over
time, reflecting the fact that their probabilities of payment
decrease as the likelihood of survival decreases over time.
The contingent payments appear on the right-hand side
of Exhibit 9. Over any quarterly interval, expected average
CDS payouts in default are typically smaller than their
associated premiums. That is because the larger payouts
are weighted by the probabilities of default. In order to
determine the size of the payouts in default one must
assume a recovery value for the reference security. In addi-
tion, when valuing the CDS under physical measure we
must also assume a term structure of physical default rates.
For now, we can assume that we know precisely the term
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 JFI-BENZSCHAWEL:Layout 1 12/10/10 10:21 AM Page 51
structure of physical default rates for all tenors for all credit
rating categories. We will consider the implications of
estimating those probabilities in a later section.
To can calculate the present values of the premium
and contingent legs under physical measure using similar
equations as those for risk-neutral pricing in Equations (4)
and (5), except we substitute cpdt for CPDtQ such that
4N
cT
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PVpremium = ∑ dt ∗ (1 − cpdt ) ∗
t =1 4
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and
4N
PVcontingent = ∑ dt ∗ ( cpdt − cpdt −1 ) ∗ (1 − RV )
t =1
Unlike in the risk-neutral setting there is, a priori,
no expected premium that relates the PVs for the con-
tingent and premium legs. Our approach is to first calcu-
late a breakeven premium, bT, as the annualized quarterly
premium necessary to equate the present values of the
contingent and premium legs as calculated using expected
physical cash flows. That is,
4 ∗ ∑ 4t =T1 dt * (cpdt − cpdt −1 ) * (1 − RV )
bT =
∑ t4=T1 dt * (1 − cpdt )
(Note that within the asset-swap framework, bT
would correspond to the CDS premium.)
To calculate breakeven CDS premiums, we need
estimates of physical default probabilities such as those
shown in the left-hand panels of Exhibit 10 for several
points in the credit cycle. Each plot shows cumulative
default curves by rating. Default rates are obtained from
historical data and combined with values obtained from
a market-based Merton-type model as described in the
Appendix.12 The physical CPD values at the left in
Exhibit 10 are used along with the assumption of an
average 40% recovery value in default to generate the
breakeven CDS premium curves in the corresponding
right panels of the exhibit. The top plots are for the high
liquidity, tight spread environment of March 2006, with
values in the middle panels taken at cyclical wide spreads,
and those in the lower graphs from a more average spread
and default environment. Notice that default curves are
WINTER 2011
ordered by ratings and show only slight adjustments with
changes in the credit cycle. However, breakeven spread
premiums required by sellers of protection vary by more
than a factor of 10 over the cycle.
We can compare market CDS spreads with the
inferred breakeven spreads to determine CDS risk pre-
miums above the calculated compensation for default. That
is, we use market values of CDS premiums to infer the
excess compensation required by sellers of protection, who
(9) are “long” credit exposure, for their large promised pay-
outs in the event of default. Exhibit 11 displays CDS spreads
by tenor and rating category for the same three points in
the credit cycle as in Exhibit 10. Notice that, like breakeven
CDS spreads, market CDS premiums also vary greatly over
the credit cycle. For example, CDS spreads in the top left-
(10)
hand panel, obtained during the high-liquidity, pre-crisis
period, are relatively tight with even CCC spreads below
1,000 bps. In contrast, the CDS spreads in the middle panel
near the height of the crisis are nearly a factor of 10 larger
than those three years earlier. Finally, as the crisis abated
in 2010, spreads have returned to roughly their pre-crisis
levels, as shown in the bottom panel.
The tables in the right-hand portion of Exhibit 11
display by rating and tenor the CDS risk premiums (i.e.,
the excess CDS spreads over breakeven values) at the cor-
responding points in the credit cycle. Notice that, although
most values for the risk premium in the tables are posi-
(11)
tive, during periods of relatively low spread levels, the risk
premiums for high-quality names have been negative. Of
course, it is possible that the relatively small negative risk
premiums reflect errors in our assumed default probabil-
ities and/or recovery values. However, some of these neg-
ative values are a sizable fraction of their estimated
breakeven spread premiums. If correct, these negative risk
premiums suggest that, for relatively high-quality credits
at short tenors, sellers of protection during periods of high
liquidity did not receive sufficient compensation to cover
their average expected payouts in default. More gener-
ally, spread premiums above those required to compen-
sate for default can be quite large relative to breakeven
spreads, particularly during periods of market stress as
shown in the middle table of Exhibit 11.
It is important to note that the inferred negative risk
premiums in the top and bottom tables of Exhibit 11
would likely not be evident within the CDS as bond asset-
swap framework. That is, since CDS spreads in the asset-
swap framework are thought to be spreads over LIBOR
rather than simple cash flows, adding LIBOR to the CDS
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EXHIBIT 10
Estimates of Physical Cumulative Default Probabilities (left-hand side) and Breakeven CDS Premiums
(right-hand side) by Credit Rating and Tenor for Three Different Points in the Credit Cycle
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Note: Breakeven CDS premiums are calculated using Equation (6) and the corresponding default probabilities and a recovery rate in default of 40%.
Source: Citi and Moody’s Investors Service.

premium would result in a greater spread than those shown
for breakeven. However, it would seem difficult to escape
the conclusion that in these times of high liquidity and
tight credit spreads, sellers of CDS protection have been
undercompensated for their risk.
SUMMARY AND IMPLICATIONS
We examined the assumption that credit default
swap (CDS) contracts can be replicated by bonds funded
at LIBOR along with an interest-rate swap and a repur-
chase agreement. We find limitations of the bond–CDS
equivalent hypothesis including difficulties in replicating
a bond synthetically in the CDS and repo markets and
different implicit CDS premiums for an obligor’s bonds
of the same maturity but trading at different prices rela-
tive to par. We also examined an alternative approach to
CDS valuation, one that uses assumed physical default
rates as opposed to risk-neutral default rates. The implied
cash flows from each leg under physical measure were
then discounted at appropriate risk-free rates and the
resulting breakeven premiums were compared to the
market-implied CDS spreads. Results were presented for
various rating categories and tenors for several points in

52 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS WINTER 2011

 JFI-BENZSCHAWEL:Layout 1 12/10/10 10:21 AM Page 53

EXHIBIT 11
CDS Spreads and Difference between CDS Spreads and Breakeven Spreads by Rating Category
and Tenor for Three Different Points in the Recent Credit Cycle
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Source: Citi and Markit Partners, Inc.

the credit cycle. The methodology enables measurement APPENDIX

of the minimum amount of risk premium compensation
that must be required by the protection seller to break
even for expected default. Our analyses reveal that, at
times, market CDS premiums for high-quality credits
were often insufficient to compensate sellers of protection
for expected payouts from default. Furthermore, analyses
of CDS cash flows under physical measure highlight asym-
metries between risk premiums received by investors in
bonds versus CDS that are not evident from similar com-
parisons within the CDS as asset-swap framework.
ESTIMATING PHYSICAL DEFAULT
PROBABILITIES
A critical assumption underlying the proposed method-
ology is that cumulative default functions over time are known
for all credits. Fortunately, the credit rating agencies, such as
Moody’s and Standard & Poor’s, have compiled extensive sta-
tistics on cumulative default rates for issues with given initial
ratings. A summary of those ratings appears in Exhibit A1.
Cumulative rates by year are shown out to 15 years, but data
are available for out to 30 years.13 Thus, by knowing the agency

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 JFI-BENZSCHAWEL:Layout 1 12/10/10 10:21 AM Page 54
EXHIBIT A1
Cumulative Default Probabilities for Bonds by Rating Category as a Function of Years since Issuance, 1920–2006
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Source: Data are from Moody’s Investors Service.
credit rating (or an analyst’s or model equivalent rating), one can
derive the probabilities of default for each successive time period.
One problem with using historical default rates for deter-
mining default probabilities is that default rates are credit-cycle-
dependent, ranging from over 12% in some years to less than 1%
in others (Altman [2003]). Thus, in practice, we use a Merton-
based contingent claims analysis model to derive estimates of
default probabilities from one to five years and historical values
after that. For example, Exhibit A1 shows default probabilities
out to 15 years constructed as a combination of marginal default
rates in years 1–5 from Sobehart and Keenan’s Hybrid Proba-
bility of Default (HPD) model14 and marginal rates from rating
agencies historical studies after that. For bonds longer than 15
years, we fix the marginal rate at the 15-year value for that rating
category. Although there are slight kinks in the default func-
tions at five years where the model and historical data meet,
smoothing techniques could be used to adjust those rates. Since
we think that the best estimate of marginal default rates after five
years are average values, we use those. Finally, a preferred method
would be to implement the entire pricing model described
herein using stochastic default probabilities and stochastic and
negatively correlated recovery values. Although we have imple-
mented that methodology in other applications (Benzschawel
et al. [2005]), we have not yet explored the implications of those
methods on our estimates of risky discount rates.
ENDNOTES
1
In fact, determination of what constitutes a credit event
can be quite complex and a matter of some debate. In general,
a credit event is a legally defined event that includes bankruptcy,
failure-to-pay, or restructuring. The ISDN and Markit Partners
have devised a procedure whereby consenting parties may resolve
the issue of a credit event via binding arbitration (Markit Part-
ners [2009]).
2
There are many sources for a basic overview of the credit
default swap contract. For example, see Rajan [2007].
54 CREDIT DEFAULT SWAPS: A CASH FLOW ANALYSIS
3
This assumes no premium for counterparty risk. Typi-
cally, counterparty risk has been mitigated by requiring coun-
terparties to post margin in response to mark-to-market losses
on CDS contracts. Throughout this discussion, we can con-
sider CDS as being traded between AA rated banks whose
funding rates are LIBOR.
4
The Z-spread is the yield spread of a bond referenced
to the zero-coupon swap curve rather than the riskless zero
curve usually inferred from U.S. Treasury yields.
5
Throughout this example, we assume that both obligors
are able to fund at LIBOR and that none of the securities in
question are trading as special in the repo market. Within the
no-arbitrate theory, the lack of LIBOR financing and frictions
in borrowing the securities in the repo market are responsible,
at least in part, for the fact that there is rarely a non-zero basis
between cash bonds and their corresponding CDS.
6
The CDS premium is commonly, but inappropriately,
called the CDS spread based on its assumed relationship to the
spread to LIBOR of its reference bond. While useful in some
circumstances, calling the CDS premium a spread obscures the
fact that, unlike bond coupons of which the spread is a fraction
of the entire cash flow, the premium constitutes the entire pay-
ment from the protection buyer.
7
The CDX.NA.IG is a basket of 125 North-American
investment-grade CDS contracts. A new index is issued every
six months. For a detailed description of CDS indexes, see
Markit Partners [2008].
8
We assume for the moment that there is no cost of ter-
minating the repo (i.e., that repo rates on the security have not
changed). Of course, any change in that rate would only com-
plicate matters as well.
9
In fact, those bonds might not all trade at the same cash
flow yield due to the different losses on all three bonds in default.
For example, assuming a 40% recovery value, investor A would
lose 60 points in default, whereas investors B and C would lose
45 and 75 points, respectively.
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 JFI-BENZSCHAWEL:Layout 1 12/10/10 10:21 AM Page 55
10
Since CDS contracts trade in units of 100 face of prin-
cipal, it is not possible to buy protection on only 75 points.
However, for any reasonably sized position, one could purchase
protection on exactly 75% of the outstanding face value of their
bond investment.
11
Of course, we can not directly observe physical default
rates and must estimate those using credit ratings’ historical
default rates or some other model-based estimate. In fact, risk-
neutral default rates cannot be observed directly either, requiring
an assumed recovery rates. Still, we have an additional source
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of uncertainly under the physical measure resulting from esti-
mates of physical defaults.
The Journal of Fixed Income 2010.20.3:40-55. Downloaded from www.iijournals.com by BARUCH COLLEGE on 03/12/11.
12
Estimates of physical default probabilities are critical
for pricing under physical measure and our approach is to take
historical cumulative default rates and modify them for credit
cycle dependence using a hybrid structural/statistical default
model.
13
See Corporate Default and Recovery Rates, 1920–2007,
Moody’s Investors Service, February 2008, and Default, Transi-
tion and Recovery: 2007 Annual Global Corporate Default Study and
Rating Transitions, Standard & Poor’s, February 5, 2008.
14
The HPD model combines a contingent claims approach
of Merton with an Altman-like statistical approach. See Sobe-
hart and Keenan [2002, 2003].
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To order reprints of this article, please contact Dewey Palmieri at
dpalmieri@iijournals.com or 212-224-3675.
THE JOURNAL OF FIXED INCOME 55