Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

No 2005:44: Using Credit Derivatives to Compute Market-Wide Default Probability Term Structures

Hans Byström ()
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Hans Byström: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

Abstract: In this paper we suggest a simple way of backing out market-wide risk-neutral default probability (and default density) distributions from quoted credit default swap (CDS) index spreads. We apply the approach to two market-wide European portfolios represented by two frequently traded iTraxx Europe CDS indexes, and the resulting analytical default probability term structures are updated on a daily basis. We believe such instantaneous default probability term structures to be useful not only for risk managers in commercial banks but also for hedge funds and others involved in speculation and arbitrage as well as for supervisory authorities like central banks in their quest for financial stability.

Keywords: iTraxx; credit default swap index; default probability; term structure

JEL-codes: C20; G33

14 pages, October 25, 2005

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