Contractual terms and CDS pricing - BIS Quarterly Review, part 8, March 2005

In recent years, the market for credit default swaps (CDSs) has expanded dramatically. In these financial contracts, a sequence of payments is promised in return for protection against the credit losses in the event of default. By offering investors the chance to gain or sell risk exposure to a reference entity without buying or selling the underlying bond or loan, credit default swaps have greatly increased liquidity in credit markets. In parallel with the rapid growth of the CDS market, the menu of contractual terms available to the parties to a CDS contract has expanded as well. One major issue is the definition of a credit event that merits payout by the protection provider; another is the definition of deliverable obligation in the event of payout. The terms of the contracts as set out by the International Swaps and Derivatives Association (ISDA) have expanded over time; at present, for instance, at least four distinct clauses related to restructuring events are available in standardised form. In this special feature, we examine the effect of different restructuring clauses on the pricing of CDSs. Using data available by obligor across contracts taken from a major market data provider, we find that CDS spreads tend to be significantly higher for those contracts with a broader definition of trigger events and/or less restriction on deliverable obligations. Depending on the contract comparison, changes in the expected probability of default (or credit event) and changes in the expected losses-given-default both appear to have a significant role on pricing, as theory would suggest. The price changes associated with contractual distinctions can have significant implications for both markets and regulatory practice. Given the