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The Pricing and Risk Management of Credit Default Swaps, with a Focus on the ISDA Model
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Abstract
In the paper we detail the reduced form or hazard rate method of pricing credit default
swaps, which is a market standard. We then show exactly how the ISDA standard CDS
model works, and how it can be independently implemented. Particular attention is paid to
the accrual on default formula: We show that the original formula in the standard model is
slightly wrong, but more importantly the proposed fix by Markit is also incorrect and gives
a larger error than the original formula.
We finish by discussing the common risk factors used by CDS traders, and how these
numbers can be calculated analytically from the ISDA model.