i am a bit confused regarding the CDS spread. Is the CDS spread the premium paid to protect against a default? Or, as it mentions a spread, is it a spread over libor?
This might sound stupid but I do not get the reason for the “spread” which would imply a spread over some benchmark…
A CDS spread is nothing more than a fancy name for the premium paid for the CDS. If you want to think of it as a spread, it’s a spread over zero.
Just an additional point. Let’s say we have a 5 year CDS at 70bps as we have it now for some large banks. Based on that, can we determine at what rate is the bank borrowing over 5 years? Or is there no link between CDS and coupon level (yield to maturity to be precise)?
Just to add a little detail here:
The actual premium paid will be the premium paid to protect against default, this will be set by the terms of the contract. Generally, CDS is standardized to a 1% or 5% premium. The credit spread will reflect the “effective” premium paid (since its balanced out by upfront premium/discount), but not the actual premium paid on a running basis.
The credit spread is intended to represent compensation in excess of a benchmark, usually LIBOR, that’s required for bearing credit risk. I think this is relevant given you should be able to use credit spreads to compare risk between cash and derivative instruments and replicate a cash bond position, synthetically, with zero arbitrage.