This paper presents and tests a model to price Credit Default Swaps (CDS) using the credit risk information extracted from the firms ’ bond market prices. Six Spanish firms are used in the analysis (BBVA, Caja Madrid, Endesa, Repsol YPF, SCH and Telefonica), which derives daily prices for the firms ’ CDS covering the period from April 2001 to April 2002. The model is shown to produce CDS prices more volatile than market quotes and to perform better the higher the firm’s credit quality. Additionally, it is shown that the choice of the recovery rate does not affect the model implied CDS prices. The model is simple, the calibration and pricing procedure is quick, and the paper is intended as an introduction to credit derivatives pricing.

The revaluation of collateralized debt obligations (CDOs) plays a significant role in the ongoing 2007-2009 credit crisis. Starting in August 2007, a large amount of initially AAA rated CDO securities are substantially downgraded, some directly to junk grade. This paper explores two structural sources of CDO mispricing: modeling difficulty and data limitation. Simulating the frailty correlated default model of Duffie, Eckner, Horel, and Saita (2008), we show that CDO mis-pricing can be partly attributed to model misspecifications, as well as limited availability of historical data on CDO collateral assets. This simulation result is consistent with empirical evidence on historical performance of a sample of 279 CDOs. The frailty model estimated with adequate historical data would have reduced the amount of AAA rated CDO securities by 12 % on average. The frailty model has predictive power for the subsequent downgrading of AAA rated CDO tranches. Our study addresses practical issues on financial innovations and provides guidance for corresponding risk management. We thank for remarks from Andrew Carverhill, Wing Suen and seminar participants at the university