How is a CDS spread decomposed into its components?

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AcadiFi · Accepted Answer

A CDS spread can be decomposed approximately as: spread equals expected loss plus credit risk premium plus liquidity premium plus counterparty and basis adjustments. Expected loss equals risk-neutral probability of default times loss given default (LGD, typically 60%). For Vanora Logistics with 2% annual risk-neutral PD and 60% LGD, the expected loss component is 120bp. If the observed CDS spread is 210bp, the remaining 90bp is non-default compensation: roughly 60bp credit risk premium (compensation for bearing systematic default risk correlated with market downturns) and 30bp liquidity premium (CDS contracts can be costly to exit in stress). The wedge between risk-neutral and physical default probabilities is significant — empirically risk-neutral PDs are often 2-4x physical PDs for investment grade. Here's a mental model of the decomposition. ```mermaid flowchart LR A[CDS Spread
210 bps] --> B[Expected Loss
120 bps] A --> C[Risk Premium
60 bps] A --> D[Liquidity
30 bps] ``` Practical implication: if you are pricing a synthetic CDO, you need risk-neutral PDs implied from CDS, not physical PDs from historical data. Using physical PDs would dramatically underprice the tranches. For regulatory capital, the expected loss component maps to IRB expected loss, while unexpected loss components feed capital requirements.

How is a CDS spread decomposed into its components?

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