Discuess the statement about the pricing, valuation and sensitivities Essay

Discuess the statement about the pricing, valuation and sensitivities of Credit default Swaps Spreads by presenting a critical r - Essay Example Secondly, it presents a review of sensitivities and spillover effects on CDS spreads from bond, equity and options markets. Under this, the market that has the greatest influence is identified after considering statistical evidence from various sources. Finally, the report reviews credit default swaps in the context of monitoring sovereign risks in both developed and emerging market economies. This seeks to demonstrate how credit default spreads behave in tranquil and volatile market environments. In addition, the importance of CDS market development in emerging economies is also highlighted in this report. 2.0 Background Credit default spreads (CDS) are recent innovation in the management of credit risks. They have gained popularity in the management of both single name and sovereign debt risks. The market is valued based on information from related underlying equity, bond and their options markets. However, various challenges have been experienced when dealing with CDS markets. The se challenges include pricing of CDS spreads, lack of exchanges for trading credit derivatives, manipulation of accounting information, among others. Pricing of the CDS spreads is not an easy task. Though various models have been put forward by many researchers, there is no universally accepted method of computing the price of CDS. Another challenge is the lack of exchanges for trading credit derivatives. CDS quotes are therefore obtained over the counter (OTC) and may not be reliable for estimating the CDS spreads. Spillover effects from the bond, equity, and options markets also affect the CDS spreads. The extent to which these markets impacts on the CDS spreads is not clearly known despite the various statistical methods posted by different researchers. Some suggested that equity markets have the greatest spillover effects on the CDS spreads while others argued that options market are the major contributors. Credit default swaps have been fully taken up in the developed economies while the emerging economies are still struggling to catch up. The way in which CDS behaves in tranquil and volatile market environments has sparked serious research. Many questions concerning CDS markets and their importance in the emerging economies have been raised by various researchers. How are sovereign risks managed by these economies? The application CDS in managing risks is a new innovation that requires further research. 3.0 Credit Default Swaps 3.1 Determination of the price of a single name CDS security. Many approaches of determining CDS spreads have been put forward by various researchers. One commonly used approach for pricing a derivative is by finding a portfolio of assets whose returns matches that of the derivative replicated. Duffie & Singleton (2003) and Lando (2004) suggested such portfolios in their research. This strategy may not work in a situation where similar replicating instruments needed for replicating the portfolio are not issued by the issuer whose CDS’s are being replicated. In addition, what happens to the replicating portfolio when the CDS contract ends after a credit event? Another approach of pricing CDS spreads is to determine the value of spread which equates the net present value of the expected value of the coupon to the net present value of the expected value of the payoff. Hull & White (2001) used this approach to formally derive the pricing formula. They assumed that interest rates, recovery rates and default