Fighting with volatility (TT Mar09 p36-37)

At the tail end of 2008 the dislocations in the funding markets, which even affected the banks themselves, triggered a new concept in the pricing of lending to corporates – namely, the idea of pricing at a variable margin over Libor with the margin based on the credit default swap (CDS) spread. While this is no longer flavour of the month, it is still worth considering the pros and cons of such a basis for loan pricing. For most borrowers certainty on the credit margin is important while for others there may be a trade-off to be made to increase the supply of willing lenders. Some may expect their CDS price to be declining and therefore see an advantage in CDS-based pricing compared with a (higher) fixed margin.