Spillover effects from the bond, equity, and options markets also affect the CDS spreads. The extent to which these markets impacts on the CDS spreads is not clearly known despite the various statistical methods posted by different researchers. Some suggested that equity markets have the greatest spillover effects on the CDS spreads while others argued that options market are the major contributors. Credit default swaps have been fully taken up in the developed economies while the emerging economies are still struggling to catch up. The way in which CDS behaves in tranquil and volatile market environments has sparked serious research.
Many questions concerning CDS markets and their importance in the emerging economies have been raised by various researchers. How are sovereign risks managed by these economies? The application CDS in managing risks is a new innovation that requires further research. Many approaches of determining CDS spreads have been put forward by various researchers. One commonly used approach for pricing a derivative is by finding a portfolio of assets whose returns matches that of the derivative replicated. Duffie & Singleton (2003) and Lando (2004) suggested such portfolios in their research.
This strategy may not work in a situation where similar replicating instruments needed for replicating the portfolio are not issued by the issuer whose CDS’s are being replicated. In addition, what happens to the replicating portfolio when the CDS contract ends after a credit event? Another approach of pricing CDS spreads is to determine the value of spread which equates the net present value of the expected value of the coupon to the net present value of the expected value of the payoff.
Hull & White (2001) used this approach to formally derive the pricing formula. They assumed that interest rates, recovery rates and default probabilities are independent. The result of their sensitivity tests showed that the valuation of a vanilla CDS was not sensitive to the expected recovery rate but this was not the case for a binary CDS. Moreover, a spreadsheet based example, which shows an implementation of such an approach, is posted by Hull (2007) in his text book. Even commercial firms use algorithms which are not significantly different from this simple approach.
Despite the assumption made by Hull (2007) that a default can only take place bi-annually; the current technology can accommodate daily defaults’
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