PABLO GALVAN

CDS Valuation
1 . VALUI NG SI NGLE- NAME CREDI T DEFAULT SWAPS.
2. VALUI NG PORTFOLI O PRODUCTS.
3. USE OF COPULAS [ TI ME PERMI TTI NG] .
OVERVIEW OF CONTENTS
1 . CDS SOME CONTRACTUAL I SSUES.
2. PROBABI LI TY OF DEFAULT AND THE TI MI NG OF
DEFAULT.
3. RECOVERY RATE ASSUMPTI ONS.
4. SI NGLE- NAME CDS.
5. USI NG ASSET SWAPS.
6. PORTFOLI O CDS.
7 . CONCLUSI ONS.
OVERVIEW OF CONTENTS
Contractual features
ISDA documentation on credit derivatives issued in 1999
and modified to deal with deliverable reference assets in
case of financial restructurings forms the basis for CDS
contractual provisions. [Visit ISDA website and familiarize
yourself with these documents].
Reference entity whose obligations form the underlying
source of credit risk and on which protection is sold and
bought.
Terms include stated maturity, notional amounts, accrual
rules, periodicity of payments, etc.
Contractual features
Credit Events are the trigger events that activate payment
notices and payments. They may include a broad set of
events such as a) bankruptcy, b) repudiation, c)
restructurings, d) failure to pay when due, e) cross-default,
f) acceleration, etc.
Contingent payments may stipulate a) physical delivery,
b) cash settlement or c) a flat payment such as a fixed
percentage of the notional principal. Physical delivery may
confer some delivery options from a menu of reference
assets. Cash settlement may involve polling of a number of
dealers to arrive at a mutually agreeable set of prices.
Pricing Principles Single Name CDS
. 0 at firm s obligor'
the of Value
0
=
=
t
V
Time
t=0
Barrier level
t=time to default
CDS Valuation
Note that typically we need to estimate a number of parameters in
valuing CDS. Sometimes, we may use the calibration technique: use
liquid benchmark CDS quotes to reverse engineer the parameters
and then use them to value other CDS.
This type of technique is widely used in sovereign debt valuation. Let
us assume that the latent variable follows a normal process shown
below:
dz dt dV + =
We now have three parameters to estimate: the starting
value of V, drift and volatility.
Pricing Principles Sovereign debt
. 0 at capacity
service debt s Country'
0
=
=
t
V
Time
t=0
Barrier level
t=time to default
The barrier is typically set to zero.
t
t V
e
t
V
t g
2
2
0
2
) (
3 2
0
2
) (
: as default" to time " the of function
density the determine can we variable,
state latent for the process a Given

=
The Time to Default and its density
|

\
|
+ |

\
| +
=

t
t V
N
t
t V
N e t G
V

0 0
2
2
0
) (
: below shown
as density the g integratin by obtained
is default to time of on distributi The
The Distribution of Time to Default
CDS Valuation
Given a process for the value of the obligors firm [which is a
latent state variable], we can determine the implied
distribution of the time to default.
Knowing the distribution of time to default, we can then
determine the present value of the credit default swap
spread payments until default.
The present value of the contingent payment can be valued
once we estimate the recovery rates and the delivery options
in the CDS contract.
Default Probability
Default Probability
i. -
ii. -
i. -
CDS Valuation
CDS Valuation
i. -
ii. -
iii. -
CDS Spread
Value of CDS:
CDS Spread:
CDS Valuation
The present value of the credit default swap spread
payments until default is given by:
In the equation above, G(t) is the distribution of default
time, and S is the CDS rate that is paid. The present value of
the contingent payment can be valued once we estimate the
recovery rates and the delivery options in the CDS contract.
[ ]

T
rt
dt e t G S
0
) ( 1
CDS Valuation
The present value of the contingent payment with a recovery rate
of X and no delivery options is:

T
rt
T
rt
T
rt
dt e t G
dt e t g X
S
dt e t g X
0
0
0
. )] ( 1 [
. ) ( ) 1 (
: rate CDS for the solving
and equal two the Setting
. ) ( ) 1 (
CDS Valuation
Using Monte Carlo simulation, we can determine the
credit default swap rate on a path by path basis in this
model.
By using the market CDS rates for a liquid single-
name CDS we can calibrate the parameters of the
model.
For example, if we have data on 2-yr, 3-yr and 5-yr
CDS rates for a name we can use those to calibrate the
three unknown parameters of the model.
CDS Valuation
Note that the CDS rate depends on a) recovery rate
assumption, b) the discounting rate assumption, c) the
default time distribution assumption and d) the 3
parameters which were estimated.
Recovery rate information is typically obtained from rating
agencies for obligors of different credit standing.
The discount rate is based on swap curve and repo rates as
opposed to the Treasury curve.
The default time distribution depends on the process that
we have specified for the latent state variable. In this case
the distribution is normal.
CDS Valuation
Since credit events are rare [relatively speaking] they are
better modeled as extreme events. To do this we need fatter
tails in the distributions than the one that we have used.
This could be done by introducing a jump component in the
latent state variable, for example.
This observation is particularly important when we move to
portfolio CDS wherein several names may be thrown
together in the context of a portfolio.
1. Asset swaps are frequently related to the CDS
rates. To see the connection between the two
markets let us look at the asset swap markets.
Asset Swaps as a Source of price discovery
Reference asset
Fixed rate Bond
Swap dealer
Pay fixed coupon of the
Fixed rate asset
Receive LIBOR+ 20 bps
In an asset swap the institution holding an asset [a fixed rate bond, in this example] decides
to do a swap which allows it to pay fixed and receive an asset swap rate which is LIBOR plus
a spread.
1 . TYPI CALLY, THE ASSET SWAP MATURI TY WI LL MATCH
THE MATURI TY OF THE REFERENCE ASSET.
2. I F THERE I S A CREDI T EVENT I N THE REFERENCE
ASSET, THEN THE I NSTI TUTI ON I S STI LL
RESPONSI BLE FOR THE PAYMENTS I N THE I NTEREST
RATE SWAP.
3. SWAP COUNTERPARTY HAS A CREDI T EXPOSURE TO
THE I NSTI TUTI ON.
4. CREDI T DEFAULT SWAP ATTEMPTS TO OVERCOME
SOME OF THESE I SSUES.
Asset Swaps as a Source of price discovery
1. Consider the seller of protection. He can a) short the
reference asset in repo markets, b) receive the
coupon of the asset in an asset swap and b) invest
CDS premium proceeds in risk-free asset.
2. If there is no credit event in the reference asset, then
the seller of protection will have offsetting fixed-rate
cash flows. The present value of CDS rate must equal
the present value of the spread between the repo rate
and the asset swap rate.
Combining Asset Swaps with CDS
Combining Asset Swaps and CDS
Reverse Repo
agreement
Seller of Protection
Receives repo rate
Pays fixed rate
Buyer of
protection
CDS premium
Contingent
payment
{ } . 25bps) (LIBOR - Repo
spread
that the require therefore We
0
0
(

+ =
(

PV
CDS PV
Reference
Asset
Fixed
rate
Libor+25 bps
Conditional on
no credit event
1 . I F THERE I S A CREDI T EVENT I N THE REFERENCE
ASSET, THEN THE SELLER OF PROTECTI ON CAN BUY
THE REFERENCE ASSET AT THE CURRENT LOW PRI CE
[ RECOVERY RATE?] AND COVER THE SHORT POSI TI ON
I N THE REPO MARKET. THE REPO DESK WI LL PAY THE
ORI GI NAL AMOUNT [ PRESUMABLY PAR] PLUS THE
REPO I NTEREST. THE SELLER WI LL BE ABLE TO USE
THE PROCEEDS TO PAY THE CONTI NGENT PAYMENT
EQUAL TO THE PAR VALUE MI NUS THE VALUE OF THE
ASSET RECOVERY. THE ASSET SWAP POSI TI ON CAN
BE TERMI NATED.
Combining Asset Swaps with CDS
1 . ASSET SWAP MAY HAVE A SPECI FI C REFERENCE
ASSET WHI LE THE CDS MAY HAVE A DELI VERABLE
BASKET OF REFERENCE ASSETS.
2. THE CREDI T EVENTS DESCRI BED I N CDS MAY BE
QUI TE BROAD AND THI S MAY I NCREASE THE CDS
RATE.
3. THE LI QUI DI TY I N THE TWO MARKETS MAY BE QUI TE
DI FFERENT.
Asset Swap rates versus CDS rates
1. In a portfolio CDS, a number of reference assets are
placed in a pool in various notional amounts.
2. The description of portfolio CDS is given in the
course packet. [One example is presented next].
3. The key dimension is the default correlation: in
effect, higher the default correlation, greater is the
portfolio CDS value dependent on market wide
factors. This produces in general a fatter tail risk in
the portfolio CDS.
4. How do we assess the protection extended to super-
senior tranches?
Portfolio CDS
Source: Bank of England, Financial Stability Review June 2001
Portfolio CDS Valuation
1. We will simulate the latent state variable for each
name in the portfolio CDS based on calibrated parameters
from single name CDS. The process will have an idiosyncratic
shock and a market-wide shock weighted by correlation of default.
2. We will record for each path number of defaults and based
on recovery rates assumptions, we can determine the extent of
losses to the senior and subordinated tranches.
3. We repeat this many times to determine the average loss
experience at different levels of subordination. This can be the
basis for credit enhancements to achieve a certain credit rating.