Broadly following are two theories for pricing CDS.
(1) Probability Model- This model is based on the present value of a series of cash flows weighted by their respective probability of non-default. This model is based on following four inputs.
(a) Issue Premium
(b) Recovery Rate
(c) Credit Curve for reference entity and
(a) Inter banking offering rates e.g. LIBOR, MIBOR etc.
(2) No Arbitrage Model- This approach was advocated by Duffie as well as Hull-White. This model is based on following assumptions:
(a) There is zero cost of unwinding the fixed leg of the swap on default.
(b) There is no risk free arbitrage.
While the Duffie used the LIBOR as the risk-free rate, whereas Hull and White used US Treasuries as the risk free rate. As per this model, price is derived by calculating the asset swap spread of a bond.
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