Z Spreads and Implied PD

rfontes · June 22nd, 2011, 4:57 pm

Hi All,I've been told the formula:1 - exp(-CDS*T/LGD)works well for getting implied PDs if CDS prices are available. I've also been told that z-spreads can be used as a proxy. Does the same formula apply for z-spreads? Also, how reliable are the z-spreads implied PDs relative to the CDS implied PDs? Thanks!

bearish · June 22nd, 2011, 8:27 pm

Your formula is based on a flat hazard rate approximation and will produce implied risk neutral PDs. In a suitably idealized world (flat curves, the Libor swap curve gives you the right discount rates, no liquidity/funding effects), the Z spread of a par bond should be close to the CDS spread of the same maturity. In the real world, there will usually be a basis between the two, but I have seen people do crazier things.

rfontes · June 24th, 2011, 12:31 pm

Thank you!

vilen · June 28th, 2011, 3:04 pm

here are 1-year Ford implied Pds (88.57 bps par and 40% recovery)(i) .013817 - based on the actual par spread formula (ii) .014762 - based on (iii) .014696 - based on as for differences between z-spread and par spread look at this doc