A credit default swap is a financial agreement that is effectively an insurance policy that pays out in the event of a default on a loan. The "swap" is simply the deal itself: an exchange of a guaranteed fixed payment, similar to an insurance premium, for a conditional payment made only in certain circumstances. The most notable aspect of a credit default swap is that the person making the fixed payment does not have to have any connection to the underlying loan, meaning it can be used simply as a speculative investment rather than a form of insurance. Credit default swap pricing is therefore technically just a matter of negotiation between the two parties in a deal, though it is influenced by factors such as the terms of the deal, the likelihood of the default occurring, and the comparative returns on other forms of investing.
The most common method of credit default swap pricing is to use a model. This involves creating a substantially objective system for finding a logical price for a particular credit default swap. An investor might therefore take out a credit default swap if he were able to get it at a more favorable price than this. Though such a deal doesn't guarantee the price would pay off, it does mean the potential return is disproportionately high given the likelihood of getting the payout. A very simple analogy would be placing a bet on a horse race in which the gambler believes there is a one in five chance of the horse winning but pays 10 to 1 odds.
The probability model of credit default swap pricing takes into account four main factors. The first is the price that the investor must pay to take out the credit default swap. The second is the amount of money that will be paid out in the event of a default.
The third factor is the credit curve: a combination of how risky the loan is, and how long it will run for. The logic of using the curve that however safe or risky a loan is, the longer it runs the greater its chance of default. The fourth factor is the current LIBOR rates, which is one measure of how much banks pay one another to borrow money overnight, which ultimately influences how much bank customers pay to borrow money or receive from savings and bonds. The reason for including this in the equation is that the same credit default swap will become more or less attractive depending on how much return is available from other forms of investment, particularly ones with lower risk levels.
The precise method of using this model for credit default swap pricing is fairly complicated. Generally it involves calculating the likelihood of a default at each possible stage of a loan, for example a loan with multiple scheduled installment repayments. For each of these stages, the potential payout is adjusted to give its current worth to the investor: for example, a high potential payout that is not very to be received and a low potential payout that is very likely to be received could be calculated to have the same overall worth to the investor at the start of the deal. These multiple valuations are combined to give an overall value to the credit default swap, which can then be compared with the actual price being asked by the issuer.