Credit Risk and Credit Default Swaps

Abstract

The main objective of this bachelor thesis is to suggest a model which makesit possible to extract the implicit probability of default from the CDS spreadsand apply it to the case of Italy. The topic is inspired by the Euro zone debtcrisis and the importance of expectations in financial markets, which moti-vates for the issue on how to access probability of default on sovereigns. Thethesis presents a theoretical model for the pricing of CDS spreads. It buildson the risk neutral valuation framework which makes it possible to extractthe implied probabilities of default from the observed market CDS spreads.In addition, the model allows for the construction of a term structure of de-fault by using the bootstrapping method. The model is applied to the case ofsovereign Italy which forms the basis for a discussion of the model and someof its assumptions – including different recovery rates and the currency ofdenomination. Finally, the model is related to some of the current issues inthe public debate over the Euro zone debt crisis and the change in regulatoryregime.

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