Pricing CDS using credit transition matrices

Suppose we have the 1-year credit rating transition matrix represented by probabilities 𝑃(1) =
90% 7% 2% 1%
10% 80% 5% 5%
( ) between the ratings 𝐴, 𝐵, 𝐶, 𝐷.
10% 10% 60% 20%
0% 0% 0% 100%
Assume a CDS is written on a credit issued to a corporate rated 𝐴 on a notional of 1,000,000 USD,
expiring in 5 years , the recovery rate for that level is 50%. The credit makes yearly payments.

Assume the risk-free rates are at 4.5% level for all the terms.

1. Exponential model

The survival function of company given the initial rating 𝐴, 𝑆1 (𝑛) = 1 − 𝑒1𝑇 𝑃𝑛 𝑒4 and on the other hand
log(1−𝑒1𝑇 𝑃𝑛 𝑒4 )
is 𝑆(𝑛) = exp(−𝑛 ⋅ 𝜆(0, 𝑛)) ⇒ 𝜆(0, 𝑛) = − 𝑛

Average intensity\Rating A B C
𝝀(𝟎, 𝟏) 0.010 0.051 0.223
𝝀(𝟎, 𝟐) 0.013 0.053 0.197
𝝀(𝟎, 𝟑) 0.016 0.054 0.175
𝝀(𝟎, 𝟒) 0.019 0.054 0.156
𝝀(𝟎, 𝟓) 0.020 0.054 0.141

Using Monte Carlo methods the spreads for CDS are given by the table below

Expiry A B C
𝒔(𝟎, 𝟏) 0.6% 3.2% 12.7%
𝒔(𝟎, 𝟐) 0.8% 3.2% 10.6%
𝒔(𝟎, 𝟑) 1.0% 2.9% 9.6%
𝒔(𝟎, 𝟒) 1.0% 2.9% 8.5%
𝒔(𝟎, 𝟓) 1.2% 2.8% 7.7%

2. Piecewise exponential model

Methodology:

If the initial rating is 𝑖 for the entity issuing a bond, then 𝜆𝑖 (𝑛) = 𝑙𝑛(𝑆𝑖 (𝑛 − 1)) − 𝑙𝑛(𝑆𝑖 (𝑛)) =
1−𝑒𝑖𝑇 𝑃𝑛−1 𝑒4
𝑙𝑛 ( )
1−𝑒𝑖𝑇 𝑃𝑛 𝑒4

We get the intensity for each year in the table below:

 Intensitiy / year A B C
𝜆(0,1) 0.0006 0.0412 0.2823
𝜆(1,2) 0.0101 0.0513 0.2231
𝜆(2,3) 0.0168 0.0552 0.1714
𝜆(3,4) 0.0217 0.0558 0.1303
𝜆(4,5) 0.0254 0.0546 0.1001
𝜆(5,6) 0.0282 0.0528 0.0792

The spreads computed with Monte Carlo based on the piecewise exponential models are in the below
table:

Expiry A B C
1Y 0.7% 3.2% 15.9%
2Y 1.3% 3.0% 12.8%
3Y 1.7% 2.9% 10.2%
4Y 1.5% 2.9% 10.0%
5Y 1.4% 2.7% 8.6%