LITERATURE REVIEW

CDS Contracting and Pricing

A CDS is a contract between two parties: a protection buyer and a protection seller. The buyer makes periodic payments to the seller at a predetermined rate (known as the spread of the contract), which is quoted as basis points overa notional amount. The reference entity of the swap is usually a corporation or sovereign state with outstanding debt. The CDS spread has become an important indicator of credit condition, similar to the significance of the stock price, which reflects the fundamental value of the company. CDS contracts offered by various market makers have become almost identical in structure, allowing end users to simply shop for the best price. Therefore, generalizations of contract terms and relative efficient pricing have made CDSs the most actively traded product among credit derivatives.

In empirical investigations comparing equity variables with CDS spreads, for example, a significant negative relationship between the CDS spread and stock price has been documented by Jorion and Zhang [2007] and others. In addition to price and return, the impact of stock volatility on CDS spreads has also been proven in studies such as Hull et al. [2004a] and Ericsson et al. [2009]. Between CDSs and bonds, prior research has suggested that theoretical parity holds in the majority of cases for the two markets, with price discovery mainly taking place in the CDS market; see, for example, Hull et al. [2004b] and Longstaff et al. [2005]. When the CDS market is compared with the stock and bond markets together, the CDS market is found to be significantly more sensitive to the stock market than the bond market (Norden and Weber [2009]).