Credit Spreads are a useful way of linking yield, return, to risk, and then to the probability of default. Yield curves, which are the curves that you see on the diagram in front of you, are a useful way of creating credit risk in this way. Corporate bonds typically are higher yield than government bond yields in the equivalent length and market, since companies have higher risk of default than governments. This high yield is represented by a spread, and spread means the additional yield that tends to be given to the holders of corporate bonds, of various credit ratings, than their equivalents in government bonds. You can see, for example, on the diagram in front of you, that a 10 year government bond is yielding 1.4%. It's a low yield, which means a low risk of default. The spread between this and a B rated corporate bond is 2.6%, and so the total yield on a B rated corporate bond would be the 1.4 plus the spread, and so, 4%. And that additional yield, the spread, is a good indication of how likely the holders of the corporate bonds feel that their bonds might go wrong, in addition to those of the risk of the government bond. Another way of looking at risk is CDS or Credit Default Swaps. We won't go into the mechanism of how they work in detail, we'll just look at them as an overview. We can use them to measure risk. Now, to do that, let's understand some of the high-level qualities of a CDS. Let's say we take out a CDS, it's acting a bit like an insurance policy. It's going to be attached to a reference entity, which might be a company or a government that's issuing debt, and it's gonna act as an insurance policy for that reference entity failing in whatever obligations they have attached to that debt. Now, the debt would then be the reference asset or obligation, and then you've got the credit event, which is usually a default. And so, we might have a CDS on a company bond, company being the reference entity, bond being the reference obligation. Perhaps the credit event is a default. There'd then be a notional value, which would be the size of the bond that we're covering. And then finally, there'd be a premium. Now, the insurance is good. It means that if we as the holder of the CDS see a default in a loan, then we might get paid out and that might compensate us, and you could see this as a hedge. However, if this were free, then it would be an unlosable bet, and so it can't be free, that's not the way the market works. And so, it comes with a cost and that cost is called a premium.

Now, the premium acts as compensation for the counterparty who's writing the CDS for us. If we use the CDS, then they have to pay us. If we don't use the CDS, they keep the premium and that's their upside. The premium, it depends how risky the loan is that we're covering, how big the premium will be and this means that we can use the premium as a measure of risk. The higher the default risk, the more expensive the CDS contract will be and the higher its premium will be.