Post by Sapphire Capital on Aug 19, 2008 2:03:38 GMT 4
Risky Swaps
Ilya Gikhman
The Icfai University Journal of Derivatives Markets, Vol. V, No. 3, pp. 26-63, July 2008
Abstract:
A reduced form of risky bond pricing was presented in Gikhman's earlier work. At default date, a bond seller fails to continue to fulfill his obligation and the price of the bond drops sharply. For no-default scenarios, if the face value of the defaulted bond is $1 then the bond price just after the default is its Recovery Rate (RR). Rating agencies and theoretical models try to predict RR for companies or sovereign countries. The main theoretical problem with a risky bond or with the general debt problems is presenting the price, knowing the RR. The problem of a Credit Default Swap (CDS) pricing is somewhat an adjacent problem. Recall that the corporate bond price inversely depends on interest rate. In case of a default, the credit risk on a debt investment is related to the loss. There is a possibility for a risky bond buyer to reduce his credit risk. This can be achieved through buying a protection from the protection seller. The bondholder would pay a fixed premium up to maturity or default, whichever comes first. If default comes before maturity, the protection buyer will receive the difference between the initial face value of the bond and RR. This difference is called the 'loss given default'. This contract represents the CDS. The counterparty that pays a fixed premium is called the CDS buyer or protection buyer; the opposite party is the CDS seller. Note, that in contrast to corporate bond, CDS contract does not assume that the buyer of the CDS is the holder of the underlying bond. Also note that the underlying to the swap can be any asset. It is called a reference asset or a reference entity. Thus, CDS is a credit instrument that separates credit risk from the corresponding underlying entity. The formal type of the CDS can be described as follows: The buyer of the credit swap pays fixed rate or coupon until maturity, or default in case it occurs before the maturity. If default does occur, the protection buyer delivers cash or a default asset in exchange with the face value of the defaulted debt. These are known as cash or physical settlements.
papers.ssrn.com/sol3/papers.cfm?abstract_id=1158255
Ilya Gikhman
The Icfai University Journal of Derivatives Markets, Vol. V, No. 3, pp. 26-63, July 2008
Abstract:
A reduced form of risky bond pricing was presented in Gikhman's earlier work. At default date, a bond seller fails to continue to fulfill his obligation and the price of the bond drops sharply. For no-default scenarios, if the face value of the defaulted bond is $1 then the bond price just after the default is its Recovery Rate (RR). Rating agencies and theoretical models try to predict RR for companies or sovereign countries. The main theoretical problem with a risky bond or with the general debt problems is presenting the price, knowing the RR. The problem of a Credit Default Swap (CDS) pricing is somewhat an adjacent problem. Recall that the corporate bond price inversely depends on interest rate. In case of a default, the credit risk on a debt investment is related to the loss. There is a possibility for a risky bond buyer to reduce his credit risk. This can be achieved through buying a protection from the protection seller. The bondholder would pay a fixed premium up to maturity or default, whichever comes first. If default comes before maturity, the protection buyer will receive the difference between the initial face value of the bond and RR. This difference is called the 'loss given default'. This contract represents the CDS. The counterparty that pays a fixed premium is called the CDS buyer or protection buyer; the opposite party is the CDS seller. Note, that in contrast to corporate bond, CDS contract does not assume that the buyer of the CDS is the holder of the underlying bond. Also note that the underlying to the swap can be any asset. It is called a reference asset or a reference entity. Thus, CDS is a credit instrument that separates credit risk from the corresponding underlying entity. The formal type of the CDS can be described as follows: The buyer of the credit swap pays fixed rate or coupon until maturity, or default in case it occurs before the maturity. If default does occur, the protection buyer delivers cash or a default asset in exchange with the face value of the defaulted debt. These are known as cash or physical settlements.
papers.ssrn.com/sol3/papers.cfm?abstract_id=1158255