The benchmark bond yields capture macroeconomic factors affecting all debt securities. Credit spreads capture microeconomic factors such as expected loss from default, liquidity and taxation. Both benchmark yields and spreads do change from day to day.

Different valuation adjustments (XVA) can be used to adjust a benchmark yield to capture the impact of these different factors, e.g. credit, funding, liquidity and taxation.

Arbitrage-free valuation can be applied to judge the sensitivity of the credit spread to changes in credit risk parameters, such as the default probability and the recovery rate.

In the framework there are 4 factors:

• I. Expected exposure
• II. LGD (1 - recovery rate)
• III. POD (default probability)
• IV. Discount factors

I and IV don't change by changes in default probability and the recovery rate. CVA per year and the total CVA for all the years do change.

In general, a smaller credit spread is associated with:

• a smaller default probability
• a higher recovery rate (or a smaller LGD)

In the particular case the reading presents, the default probability has a bigger impact on the credit spread than the recovery rate. This is not always the case though.

Note that these two factors (recovery rate and default probability) explain only a small portion of credit spread variation.