I have problems understanding the formula of the price of a CDS. Why is the procentual upfront premium (from perspective of what buyer is paying) substracted from the notional to arrive at the price of the CDS? If the CDS is sold after initation, the initial buyer will have payed upfront but also receive a reduced price when selling to a third party.
What do I get wrong here? Do I have a false understanding of what the price of a CDS is representing? Thanks for helping out!
Hopefully some one will be able to run thru the specifics as I can’t get into them at the moment. I will try to come back later tonight to help, but thought I might be able to provide a quick take on logically what is happening. I am simplifying/condensing a few things to save time on my end please keep that in mind ISDA standardized CDS/CDX contracts to a 5% (HY) and 1%(IG) premium paid on a quarterly basis usually with a daycount of a/360. If you want to buy insurance from me typically you would pay me a premium over the term to protect you against some risk. If that risk occurred I would cover your losses. Now lets take the 5% example and say you were buying protection on your house and the premium you would pay me is 3% based on the risk of the event occurring. However, I only offered contracts/insurance at a flat 5% to all customers. Well you are paying more(5%) for a less risky event(deemed 3%), correct? So you get a contract worth some amount (really this would be par adjusted to 100 if you work on any accounting platforms), but I give you the the difference between 5% and 3% upfront to make us both equal. This is because I am insuring you and you are paying me at 5% which is higher than the true risk of the asset (3%). So the simple answer to what I think you are asking is that the upfront payment can come from either side of the deal. To take this one more step if you were paying 5% for insurance but the asset had risk of 7% then you would need to compensate me for the additional risk with the upfront. I feel it is important to note that I am a level 2 candidate and everything above is more from my work experience than the curriculum and just a way to think about it. Take it with a grain of salt and hope it helps a little bit. Apologies I couldn’t get into more. If anyone sees any errors please let me know so that I can edit this that no one gets the wrong idea.
Totally agree on this. The insurance buyer pays a higher coupon than he should based on the actual risk level and he receives an upfront payment to adjust for it. My question is:
Why is the procentual upfront premium (from perspective of what buyer is paying) substracted from the notional to arrive at the price of the CDS? If the CDS is sold after initation, the initial buyer will have payed upfront but also receive a reduced price when selling to a third party.
In this case, the premium is negative (insurance buyer receives), increasing the price of the CDS, which is from my view point counterintuitive to what we just discussed
CDS with CDS coupon rate of 5% while CDS spread = 3,5%, Duration = 7% -> upfront premium = -10,5% (buyer is receiving) but price = 100 - (-10,50) = 110,50 (initial buyer would additionally receive higher price)
The way I understand it and remember it for the exam, the “price” of a CDS isn’t an upfront cost to the buyer. At contract initiation when the buyer receives a payment, the higher “price” is like saying he’s getting more than the notional principal amount in a credit event (NP + upfront payment received). Similarly if the buyer pays an upfront premium, then the NP for a credit event effectively is reduced by the amount of upfront premium paid. I would gladly be proven wrong by someone.
Thanks tactics! Still if someone has a clearer explanation a) what the swap price actually represents and b) why the upfront payment from the buyer is reducing the price, I would gladly appreciate any further comments
