Credit Default Swap Framework

This article presents a framework for valuing a credit default swap (CDS) contract by taking counterparty credit risk into account. There are three sources of credit risk in CDS: the buyer, seller and reference entity. Our analysis shows that the effect of default dependencies on a CDS premium from large to small accordingly is i) the default correlation between the protection seller and the reference entity, ii) the default correlation between the protection buyer and the reference entity, and iii) the default correlation between the protection buyer and the protection seller. In particular, we find that the default correlation has substantial effects on the asset pricing and risk management.