How do we know when to use negative sign for upfront premium when CDS is sold? If the bond defaults, then the seller has to pay the buyer but is that payment called a premium? In Example 6, it isn’t clear why a negative sign is used.
I would suggest thinking about the economics of the transaction in order to understand the direction of upfront payment.
If the CDS spread is less than the coupon, it implies that the underlying is of better credit quality than a hypothetical underlying with spread = coupon. In other words - if the credit protection buyer were to pay the coupon to the credit protection seller, he would be overpaying, therefore the upfront payment would be from credit protection seller to credit protection buyer.
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Thanks for the detailed explanation! So the 1% and 5% for invesment grade and high yield debt, are these fixed coupon rates? So if the CDS spread is less than these rates, the seller will be paying?
And typically the CDS spreads would match the fixed coupon rates of 1% and 5% for investment and high yield respectively?
Correct
No, the coupon rates are just centrally set rates (by ISDA, I believe, but not 100% sure on that), and CDS spreads will typically be different.
Ok thanks so much!