Credit Default Swaps

Transcription

1

2 GGY AXIS 5001 Ynge Street Suite 1300 Trnt, ON M2N 6P6 Phne: Tll free: GGY-AXIS Fax: Web: Table f Cntents BACKGROUND... 1 CDS INDEX TRANSACTIONS... 1 PRICING AND VALUATION... 1 AXIS INTERFACE... 2 SAMPLE ASSET CELL i -

3 Backgrund A CDS is much like insurance against a bnd default. Mre precisely, a CDS is a derivative cntract under which ne party, the prtectin seller, agrees t make a payment t anther party, the prtectin buyer, in case f a credit event affecting a specified reference entity. In exchange, the prtectin buyer pays a recurring fee r cupn t the prtectin seller. There may als be an up-frnt payment. A CDS has a ntinal amunt and a defined term. Fllwing a credit event, the prtectin seller pays the difference between the ntinal amunt and the recvery value f the defaulted reference debt, less the accrued CDS cupn. The decisin as t whether a credit event has ccurred is made by an ISDA cmmittee, and the recvery rate is established at an auctin cnducted under ISDA supervisin. A CDS des nt refer t a specific bnd r debt issue, but t all debt f a specified type issued by the reference entity fr example, all senir debt. (In practice, prices f different issues cnverge n default because f crss-default and maturity acceleratin prvisins). This means that a single CDS can cver a wide range f different debt issues, and CDSs are ften mre liquid than the underlying debt. If the wner f a risky bnd buys CDS prtectin then they are in almst (but nt quite) the same psitin as the wner f a risk-free bnd. Likewise, if the wner f a risk-free bnd sells CDS prtectin then they are in much the same psitin as the wner f a risky bnd. The main differences are: The CDS cmpensates the prtectin buyer fr the lss f principal if a bnd defaults, but there is a timing difference, because payment is made at the time f default, nt the riginal maturity date. The prtectin buyer is expsed t cunterparty default risk. Hwever, CDSs are almst always fully cllateralized, and it is increasingly cmmn fr CDSs t be executed thrugh bankruptcy-remte clearinghuses. Because f the similarities between CDSs and risky bnds, the quted CDS cupn rate is usually clse t the yield spread n risky bnds. The CDS cupn is ften referred t as the CDS spread. CDS Index Transactins A CDS index transactin is similar t a single-name CDS except that it references a static basket f issuers, nt a single issuer. The ttal ntinal amunt is subdivided amng the underlying issuers. Unlike a singlename CDS the transactin des nt terminate fllwing a credit event, but the ttal ntinal amunt is reduced by the ntinal amunt f the defaulted issuer. The cupn rate remains unchanged in percentage terms, but reduces in dllar terms because f the reduced ntinal amunt. Pricing and Valuatin Standard CDS cntracts have a recurring cupn f 100 bps p.a. (500 bps fr belw-investment-grade names), and a negtiated up-frnt payment. Hwever, CDS prices are usually quted as par spreads, i.e. a hypthetical cupn rate that wuld result in a zer up-frnt payment. This is analgus t quting bnd prices in the frm f par yields. In rder t cnvert a quted CDS par spread int a dllar market value, r vice versa, it is necessary t Page 1 f 3

4 have a mdel f defaults and recvery rates. The mdel is calibrated t reprduce the quted spread, and nce calibrated the mdel is used t calculate a market value, r the ther way arund. The mdel implemented in AXIS is cnsistent with the standard ISDA mdel used fr market qutatins (see and In technical terms, this is a flat hazard rate mdel, meaning that the survival prbability ver any perid [t, T] is given by exp[ λ.(t t)], where the hazard rate λ is a cnstant. The value f λ is determined by AXIS based n the given par spread r market value. Nte that this is a market-implied (risk-neutral) hazard rate mdel that is used nly fr market value calculatins. It is nt intended as a realistic descriptin f defaults, but is simply a market cnventin fr cnverting between quted spreads and trade settlement amunts. This is similar t the way that ptin prices are ften quted in terms f Black-Schles implied vlatilities, despite the knwn shrtcmings f the Black-Schles mdel. The recvery rate fr market value calculatins is specified directly by the AXIS user. The cnventin fr market qutes is t assume 40% recveries fr senir debt and 20% fr subrdinated debt. The user is free t specify ther values, but the resulting mdel values will likely be incnsistent with market prices. AXIS uses the same flat hazard rate mdel fr CDS index transactins as fr single-name CDSs. Again, this is a market cnventin and is nt intended as a realistic descriptin f each underlying issuer s survival prbabilities. AXIS Interface Several new ptins and inputs have been added t the AXIS asset cell. Asset Features Calculatin type has a new ptin, 25 Credit Default Swap. Payment timing has a new ptin, 4 Based n maturity date (CDS cnventin). The reasn fr this ptin is that CDS cntracts usually have a shrt initial stub perid, s as t align the cupn payment dates and maturity dates with standard IMM dates (March 20, June 20, September 20 r December 20). With this setting there is a full cupn payment at the end f the initial stub perid, partially ffset by an accrued cupn payment n the start date. This nly makes a difference t AXIS prjectins if the first CDS cupn payment is still in the future. Otherwise, this setting is effectively the same as 3 Based n maturity date. Asset Features Credit Default Swap: This is a new sectin with tw inputs. Psitin can be 0 - Prtectin seller r 1 - Prtectin buyer. CDS spread/premium is the annualized CDS cupn rate. This is the cntractual spread established at the start f the cntract, nt the current market spread used fr valuatin purpses. Fr a standard cntract this will be either 100 bps r 500 bps. Pricing/Prjectins CDS Underlying and Margins CDS Underlying: These are new sub-sectins with tw inputs, CDS default and CDS recvery. These inputs are specified in the same way as default rates and salvage values fr bnds. If default and salvage value tables have been set up fr bnds they can be re-used fr CDSs. The reasn fr the new sub-sectins is t emphasize that these assumptins refer t the CDS reference entity, nt the CDS cunterparty. Central Clearing: If beta feature 331 ( variatin margin ) has been enabled, then the Central clearing and Price alignment interest switches can be used fr a CDS. Page 2 f 3

5 Accunting Basis Amrt Cst Basis Methd: Fr a CDS this can be 0 Zer, 1 Cst, 2 Simple amrtized cst r 6 Market value. Market Value Market value methd can be 0 Zer r 10 PV f cashflws t maturity date. Calibratin has a new ptin, 3 Slve fr par CDS spread/premium. This is similar t slving fr a yield spread based n an in-frce market value (r a future purchase price). As with yield spreads, the calibrated CDS spread can either be held cnstant r graded dwn ver time, depending n the Spread methd switch. Regardless f the calibratin switch, AXIS still slves fr a hazard rate s as t cnvert between par CDS spreads and market values. The calibratin switch determines whether r nt the par spread is calibrated t match a given in-frce market value, nt whether AXIS slves fr a hazard rate. CDS par spread: This can be a flat spread, a table specifying a par spread curve, r bth. A CDS spread table takes the same frm as a yield spread table fr bnds, and spread tables that have already been set up fr bnds can be re-used fr CDSs. If a table is specified then the CDS par spread is an interplated value based n the CDS maturity. Fr details f AXIS interplatin methdlgy see If the Calibratin switch is set t 3 Slve fr par CDS spread and a spread table is specified then AXIS slves fr a flat spread that is in additin t the interplated table value. CDS par spread maturity: This is a new switch that affects the interpretatin f a CDS par spread table. If the switch is set t 0 - Next IMM date after nminal maturity in CDS par spread table then each clumn in the spread table is taken t refer t the next IMM date after the nminal maturity date. Fr example, as f Dec 31, 2015 the 5-year clumn wuld refer t a Mar 20, 2021 maturity date. This is cnsistent with CDS market qutatin cnventins. With this setting it is nt necessary t ppulate every clumn in the spread table. Fr example, if CDS spread qutes are nly available fr 3 and 5-year nminal maturities then the ther clumns can be left blank. AXIS will ignre the blank clumns when calculating interplated spreads. If the switch is set t 1 - Same as nminal maturity date in CDS par spread table then the spread table is interpreted in the same way as fr bnds. In the abve example, the 5-year clumn wuld refer t a maturity f Dec 31, Sample Asset Cell Dataset CDS Sample Cell includes a sample cell that illustrates this feature. T use this dataset, yu will require the activatin cdes fr beta features 462 Credit Default Swap and 331 Variatin margin. Please cntact GGY fr these activatin cdes. Page 3 f 3