Q.Which of the following statements best describes how a single-name CDS contract is priced at inception?
A.If the reference entity’s credit spread trades below the standard coupon rate, the CDS contract will be priced at a premium above par because the protection buyer pays a “below market” periodic coupon.
B.If the reference entity’s credit spread trades above the standard coupon rate, the CDS contract will be priced at a discount to par because the protection seller effectively receives a “below market” periodic premium.
C.Similar to fixed-rate bonds, CDS contracts are initially priced at par with a fixed coupon and a price that changes over time as the reference entity’s credit spreads change.
Solution - Option B
Pls explain the 2nd part of option A and B. The below market and above market coupon/premium stuff
The coupon rate that protection buyer paid is usually fixed rate, thus it may below or above the rate that they should pay—the “market” rate.
This means the coupon rate the protection buyer pays is below the “market” rate that they should pay for the protection.
When the fixed coupon rate is less than the “market” rate, the protection buyer should pay an addition premium upfront and the protection seller will receive the upfront additional premium which is called the “below market” periodic premium.
Single CDS are usually based on standard contracts. With set periodoic payments
1% for investment grade, 5% for high yield
IF you want to buy protection on a company/bond with 6% spread but only pay 5% periodic payments you are paying “below market” for the risk you are protecting.
Hence you need to pay an upfront premium (Spread - coupon) x spread duration, ie (6% - 5%) x spread duration (Lets assume 3) = 3%
The CDS is quoted at 100 - upfront premium = 100 - 3 = 97.
Single CDS - periodic payment based on standard contracts
= 1% for investment grade, 5% for high yield
Here Option B indicates that if the reference entity’s credit spread is above 1% but as per the standard contract you are paying only 1% periodic payment, that means you got the contract at a discount
i.e even though the protection seller is protecting you for a credit spread of let’s say 1.5% credit spread you are paying 1% periodic payment
P.S
Reference entity = the company you are taking CDS on
In such case you pay an upfront premium to compensate the protection seller