Pricing CDSs’ capital relief

Positions in credit default swaps (CDSs) are eligible instruments to reduce some Basel III capital requirements. The value of this benefit should be reflected in the price. Chris Kenyon and Andrew Green incorporate this into a pricing model for CDSs, and show it may account for more than half the spread

The Basel Committee on Banking Supervision capital requirements known as Basel 2.5 and III – and their legal implementations such as the European Capital Requirements Directive (CRD IV) and more recently by the US Federal Reserve Board – set out specific capital charges for counterparty default risk and credit valuation adjustment (CVA) variation. The rules laid out by the committee allow for banks to reduce these charges by taking positions in appropriate credit default swaps (CDSs) and dealers