I have some very basic CDS questions, that I hope someone can help with. Please see the recent news article. I have several begginer questions, relating to the article:Per the article, it now costs $950,000 to protect $10 Million in debt for one year. 1) How does one calculate that this is "equivalent to a spread of 1,560 basis points"?2) How does one calculate that this implies "there is a 20 percent to 25 percent chance Lehman will default in this time frame"?The article further states that "Lehman's one-year default swaps closed on Wednesday at 1,156 basis points, according to data by Markit" and that the five year credit swaps "widened to around 650 basis points on Thursday after earlier jumping near 800 basis points"1) how do these swaps imply that there is a "35 percent to 40 percent chance Lehman will default over the next five years"?2) Why the big difference between the 1 and 5 year numbers?3) Didn't the article say that the one year number is equivalent to a spread of 1,560 basis points? the actual quote seems to be 1,156. Why the difference?Thanks for any help. I am learning!Lehman CDS imply 20 pct default risk in next yearThu Sep 11, 2008 3:56pm EDTNEW YORK, Sept 11 (Reuters) - Credit derivative traders are pricing in a more than 20 percent chance Lehman Brothers Holdings (LEH.N: Quote, Profile, Research, Stock Buzz) will default on its debt in the coming year, and demanding higher upfront payments on growing concerns about the bank's ability to survive.Lehman's one-year credit default swaps rose to 9.5 percent the sum insured on an upfront basis on Thursday, or $950,000 to protect $10 million in debt for one year, said a trader.This level is equivalent to a spread of 1,560 basis points, and implies there is a 20 percent to 25 percent chance Lehman will default in this time frame, said Tim Backshall, chief analyst at Credit Derivatives Research in Walnut Creek, California.Credit default swaps typically start trading on an upfront basis when concerns grow that a default is more likely, as sellers of protection grow nervous that a default could happen before they receive the quarterly premiums for the insurance.Lehman's one-year default swaps closed on Wednesday at 1,156 basis points, according to data by Markit.Five-year credit default swaps on Lehman, which are the most liquidly traded contracts, widened to around 650 basis points on Thursday after earlier jumping near 800 basis points.These swaps imply that there is a 35 percent to 40 percent chance Lehman will default over the next five years, Backshall said. (Reporting by Karen Brettell; Leslie Adler) © Thomson Reuters 2008. All rights reserved. Users may download and print extracts of content from this website for their own personal and non-commercial use only. Republication or redistribution of Thomson Reuters content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters. Thomson Reuters and its logo are registered trademarks or trademarks of the Thomson Reuters group of companies around the world.

the swaps are trading "Upfront" - so to buy your insurance you pay the seller of insurance his premium today. usually,in a less stressed credit you will pay that premium over the life of the CDS.so to insure 10mm of bonds you are paying 950m (m is a thousand). So if you think the recovery on Lehman is 40c in the dollar then should they default over the next year you will be making a payout of 6mm. so the probability of that happening if the CDS is a fair price is950m = 6mm * pp = 950,000/6,000,000 ~ 16% so you see it depends on what you think the recovery value is or Loss Given Default (LGD).to convert it to a spread, you need to know what the hazard rate.So if the hazard rate is high then this implies a high probability of default before 12 months - hence you will want a bigger spread to balance that. the spread of 1650 implies that the market is pricing is a default before 950/1650 * 12 months or in about 7-8 months.the reason 5 year CDS trades below 1 yr is because the market expects that if it doesnt default within 12 months then its going to be OK.

Thank you very much for what must be very basic questions! This makes sense, and I think I can see if I can work through the 5 year probability number myself to be sure I understand.Let me take this a step further please. I am looking on Markit and see that the CDX.NA IG index is now shows the following:1) Coupon 1.550%2) Price 100.327%3) Spread 147 I know from research that this is an aggregate equally-weighted CDS index of 125 IG issues. Would I assume a defualt probability (as you have shown) and the 147 spread and then work backwards to determine what the "upfront" equivalent would be? Also, please tell me what the price and coupon signify and how, if at all, these should be interpreted.Thanks again.

its not as easy as that unfortunately. If you want to convert spreads to unpfront you need to know the hazard rates. You can get this by bootstrapping the credit curve. I would suggest you read the Hull paper entitled "Valuing Credit Deafualt Swaps I: No counterparty default risk". although this wont exactly address you question it will shed more light on how CDS are valued.hth