Fitch CDS Pricing Consensus Curve Methodology Overview The Fitch CDS Pricing Service aims to provide greater transparency within the global Credit Derivative market. Fitch CDS Pricing is an industry-leading credit derivative pricing service that provides clients with daily access to anonymous, high quality pricing data from the leading global derivative market makers. This pricing data is collated from the Fitch CDS Contributor Service that was established in 1999. This anonymous data provision ensures the availability of timely, quality and accurate data, offering superior price transparency to that obtainable from a single market-maker. Coverage is global and data is available for almost 3,000 reference entities. The raw contributed curves are cleaned and validated to derive a consensus mean. A rich set of explanatory analytics are available including the mean and standard deviation of Recovery Rates and mid-market quotes across the full range of maturities. The Fitch CDS Pricing Service is available on a daily basis and also has the industry leading historical data going back to 1999. The cleaned data can be downloaded into Excel, or integrated into internal systems. There are multiple applications for the data, including: Building credit curves Developing analytics Benchmarking Leading indicator of changes in credit quality Market valuations
1. Consensus Calculation The Consensus Credit Curve (CCC) is a cleaned consensus credit curve for a specific reference entity. For each reference entity consensus curves are determined for each combination of ranking, currency and restructuring term. Each curve is shaded according to the level of confidence in the contributions received based on the standard deviation and the liquidity of the point with the most contributions. Contributions confidence levels are classified as: Green: Highest quality, small standard deviation and high liquidity Amber: Proceed with caution, low standard deviation and good liquidity Red: Proceed with great caution, high standard deviation and low liquidity The following tests are undertaken at each maturity to determine whether a price is an outlier and therefore excluded from the calculation: If there are two or fewer contributors, no further filtering occurs and no price is published. For three contributors, calculate the mean and if the standard deviation is less than Y% accept and publish the price. If not, recalculate the mean and standard deviation removing first the high price and then the low price. If one pair s standard deviation is less than Y% then use the consensus price determined from that pair, otherwise use the consensus created for the three contributions. For four or more contributors determine the median, then: 1) Establish the furthest point away from the median, exclude this credit point and calculate the mean. 2) If the credit point is Z% from the mean, remove the credit point. 3) If the credit point is not filtered, or only two contributors are left, or 50% of contributors have been filtered, stop. Otherwise, revert to step 1 again. The CCC confidence level is based on the percentage of standard deviation (standard deviation as a percentage of the mean) and the number of points used to derive it as shown in table 1. Table 1: CCC Colour Scheme Level * St. Dev Mean Point Count Green < = 10% > 5 Amber < = 20% > = 3 Red N / A N / A * Level is determined by the lowest criteria The following also applies to the CCC: The CCC can only be calculated from quorum 1 points. The specifics of how a CCC point is derived are readily available with the underlying data and an explanation of its use, i.e. what is excluded and included and why (Contributor Service only). The criteria used to derive a particular CCC point may change with time, however the history is maintained and the criteria and data that were applied are always available. 1 A quorum for the purposes of Fitch CDS Pricing refers to the minimum number of data points required to calculate a consensus credit curve; in this case 3 points are typically required.
2. Data Cleaning Process The following criteria are used to establish the eligibility of contributed data point s for inclusion in the mean calculation: A curve is defined as flat if greater than two points have the same value along the curve. If removing all flat contributor curves in leaves no contributor curves (i.e. all are flat curves) then the flat curves are valid for inclusion in the Service. A price in defined as stale if the contributor has not changed their value for X days, where X is defined and re-assessed on a regular basis. Exclude all stale pricing and flat curves as defined above from missing maturities calculation. The diagram below outlines the data cleaning process methodology that is applied prior to your results file being distributed.
3. Convert to Probability Space Where a contributor to Fitch Pricing Services provides only a partial credit curve for a given entity, i.e. not all par spreads for the standard tenors are received; Fitch CDS Pricing uses a hazard rate approach to calculate the inferred par spread for these missing tenors. This approach ensures that more complete curves from each contributor are available as an input for CDS entities on which Fitch Pricing Services provides pricing information. The following highlights the process through which the hazard rate, and hence the missing par spreads, are calculated: Calculate the piecewise constant hazard rate for each contributor entity curve based on the term structure of the par spreads, based on the actual contributed data points. A hazard rate is determined for each section of the maturity horizon for which quoted spreads are received. If the curve cannot be built (i.e. negative hazard rates) then the curve is rejected. Calculate the missing tenors for an individual contributor s curve using the hazard rate. For each contributor entity curve the par CDS spread is calculated for each required maturity. Where a contributed par spread is available no calculation is done and the contributed point is retained. Where there is no contributed point the hazard rate can be used to derive the par spread providing an irregular Hazard rate is not produced. For example, if no four year point is received from a contributor, then the hazard rate can be used to derive this credit point. 4. CDS Upfronts / Conventional Spreads As part of the global changes to CDS contracts implemented by ISDA s CDS Big Bang, single name North American CDS is to trade with a fixed coupon, or SNAC (Standard North American Contracts) convention. The coupon will be either 100bp or 500bp with upfront payments changing hands. It is expected that contracts with 100bp fixed coupon will generally be quoted as a Conventional Spread, and contracts with 500bp fixed coupon will be quoted in points upfront by the dealer community. The convention changes for European Corporate and Western European Sovereign CDS are very similar to the North American convention changes. The most significant difference is that the European contract retains the Modified Modified Restructuring convention. Fitch CDS pricing will use methodology stipulated by ISDA to convert from Conventional Spread to required upfront payment, and vice versa. The methodology uses constant hazard rate to translate between Conventional Spread and points upfront. Buyers of protection will also have to make a full coupon payment on the first payment date, irrespective of when the trade was struck. In return, sellers of protection will incorporate accrual rebate to the upfront payment at the time of the trade. Fitch CDS pricing will only provide clean upfronts and accruals in its daily file.
5. Flat Curves Analysis The following tests are undertaken when ascertaining whether flat curve data can be used in the mean calculation: A curve is defined as flat if greater then N points have the same value along the curve. Where N > 1. A curve may be flat in full or in part, where different portions of the curve are defined as flat. If flat or partial flat curves are allowed, there are no further tests. If all the other curves are flat, there are no further tests. For each portion of the curve that is flat: The maturities that are determined to be clean are selected and the rest are excluded from the calculation. None or all can be selected. To simplify this, because the number of combinations is fairly large, the maturity range and points to use within the range are defined by Fitch Solutions. Examples: If the whole curve is flat, allow the 3- and 5-year points only. If the 7- to 20-year is flat, allow the 10-year point. If the 6-month to 2-year is flat, allow the 1-year point. 6. Stale Pricing Determination The following tests are undertaken to ascertain whether stale price data can be used in the mean calculation: A price is defined as stale if the contributor has not changed their value for X days. Where X > 0. If stale pricing is allowed, there are no further tests. If all the other pricing is stale, there are no further tests. If the reference entity is a sovereign and the median spread value is less than S basis points, there are no further tests. Where S > 0. Select one of the following options: For this test only, new contributions to a data point are excluded if: 1. More than C% of the contributions have changed since the previous day. 2. Contributions which have not changed are also excluded. If a contribution has changed to stay in line with peer contributions, this is considered insignificant and is excluded. Where C > 0. 3. Exclude all stale pricing as defined above.
7. Outlier Identification The following tests are undertaken to determine whether a price is an outlier: If outlier pricing is allowed, there are no further tests. A minimum test limit L is set. Any price below L will be ignored. Where L > 0. If all pricing is within Z% of the median, provided Z is greater than L, there are no further tests. Figure 1: Outlier Test Illustrates how outliers are determined according to the larger range found from the minimum test L or the percentage range test, O or Z. Test 1: The point furthest away from the median is established. This point is excluded and a mean is calculated. If the point is > O% away from the mean and the divergence is greater than the minimum L, the point is excluded. Where O > 0. The test is repeated R times or until no points are rejected or until Y% of points are rejected. Where R > 0 and Y > 0. If more than Y% of points are rejected use all points. Test 2: The point furthest away from the median is established. This point is excluded and a mean and standard deviation are calculated. If the point is > N standard deviations away from the mean and the divergence is greater than the minimum L, the point is excluded. Where N > 0. The test is repeated R times or until no points are rejected or until Y% of points are rejected. Where R > 0 and Y > 0. If more than Y% of points are rejected all points are used. Special rule for only 3 contributions: Calculate mean and standard deviation of all 3 contributions. If the standard deviation of this mean > 10% then calculate the mean and standard deviation of the low and middle and the high and the middle. If the high and the low are equidistance around the middle point then use the mean of all 3 contributions. Use the pair where the standard deviation is less than 10% of its mean. Otherwise use the mean of all 3 contributions. 8. Calculate Mean and Standard Deviation The mean and standard deviation of the data not excluded by the above test is calculated. The standard deviation is calculated using the non-biased or n-1 method, sample standard deviation.
Contributor Consensus Data Contributor consensus data adds value for a number of reasons, especially as the data is derived from market-makers. The consensus is a cleaned average of the prices the market-makers are using to mark its own books and records. Not every entity trades daily or even weekly, but contributors have to mark their own books to meet both audit and regulatory requirements. Consensus results offer colour on illiquid entities as well as a traded consensus view. Benefits of Fitch CDS Pricing Services Fitch Pricing Services are differentiated through our data cleaning expertise and industry leading history. We do not blend different currency and restructuring automatically. Our data is cleaned in probability and spread space. Our data results do not curve fit automatically thereby improving the accuracy of modelling and valuations; curve fitting in volatile market conditions can produce inaccurate results. Client research shows that our data better represents the market as our methodology does not force the data to follow any specific shape, whereas a curve fit methodology can distort the data particularly at the short end of the curve. All Fitch CDS Pricing consortium members are leading global market-makers. We provide full term structure and not just individual points on curves. We provide bespoke exception reports highlighting problematic areas helping risk groups to prioritise. Our coverage of data is approx 3,000 reference entities and maintains historical data to 1999. We provide a benchmarking service for highly illiquid names. We also provide a liquidity measure that shows you how liquid an entity is globally, regionally and by sector. This has also proved itself a good research tool by directing attention to entities which are about to become news. Fitch Solutions Products Fitch Solutions uses the consensus results in areas of its broader service offering, namely liquidity scores and CDS implied ratings. The raw contributions and contributor-specific statistics are never seen outside the Fitch Solutions Product Department; none of this data is passed on or is allowed to be passed on to any other Fitch business unit including Fitch Ratings. Contact Global CDS Contributor Services Support T: +44 20 3530 2222 F: +44 20 3530 1500 E: contributors@fitchsolutions.com Global Offices New York T: +1 212 908 0800 E: usaclientservices@fitchsolutions.com London T: +44 20 3530 2400 E: client.services@fitchsolutions.com Tokyo T: +81 3 3288 2628 E: tokyoclient.services@fitchsolutions.com Hong Kong T: +852 2263 9999 E: asiaclient.services@fitchsolutions.com For more information For more information about Fitch Solutions product and service offerings, visit www.fitchsolutions.com About Fitch Solutions Fitch Solutions is committed to delivering value beyond the rating by providing a range of fixed-income products and professional development services to the global financial community. In addition to offering proprietary content, the firm also distributes the ratings, research, financial data and analytical tools of Fitch Ratings through a variety of platforms. With innovation and experience behind every product and service we bring to market, our flexible offerings are designed to meet the diverse needs of the credit markets. Drawing upon a wealth of expertise, skills, and market insight, we provide financial professionals worldwide with the intelligence they need to make more informed risk management and investment decisions. Fitch Solutions is part of the Fitch Group, a jointly owned subsidiary of Fimalac, S.A. and Hearst Corporation. For additional information, please visit www.fitchsolutions.com. FS20128F2/040212 www.fitchsolutions.com