Loan CDS, Cancelability and the Basis

[Sapphire Capital]

Loan CDS, Cancelability and the Basis

Luis O'Shea
RiskMetrics Group


February 09, 2009


Abstract:
In our third paper, we return to the pricing of credit derivatives. Luis O’Shea examines the relatively new market for loan-only credit default swaps (LCDS). After introducing this derivative and discussing a few salient differences between LCDS and traditional corporate CDS, Luis presents a number of pricing frameworks. He shows that even after adjusting for the most obvious difference between LCDS and CDS - that is, that the expected recovery rate on LCDS is significantly higher - a significant basis remains between these two derivatives. For firms that issue both loans and bonds, the LCDS market seems to imply higher default probabilities. Accounting for the next difference between the products - that LCDS can cancel without defaulting - does not appear to explain this basis either. Luis proposes a joint model for CDS and LCDS that posits uncertainty in a firm’s initial credit state, and shows that this model can indeed account for much of the basis we observe.

papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1481864_code1305710.pdf?abstractid=1481864&mirid=1

[ANTOINE BOUVERET]

"The Credit Default Swap (CDS) Market" Free Download

Trresor Economics, No. 52, February 2009

ANTOINE BOUVERET, Observatoire Français des Conjonctures Economiques (OFCE)
Email: [e-mail]

One of the earliest signs of the financial crisis in summer 2007 was the plunge in the indicaaes compiled from credit default swaps (CDSs) on a basket of subprimebacked bonds. Recently, the worsening situation in the emerging countries has been perceptible in the steep rise of CDS spreads on their sovereign bonds. Credit default swaps protect investors against credit events on reference corporate or sovereign bonds. By guaranteeing against default risk, they also allow banks to reduce their equity requirements. In sum, CDSs are a hedging tool widely used by financial agents such as banks and hedge funds, which explains the CDS market's significant expansion in the past five years.

As in over-the-counter (OTC) markets, counterparty risk is high, for there is no CDS clearing house to underwrite commitments through a system of margin calls and collateral. The failure of a major player such as Lehman Brothers or AIG can thus aggravate systemic risk, although several procedures established by the International Swaps and Derivatives Association (ISDA) have, until now, proven their efficiency for unwinding CDS contracts.

The growth of CDSs helps lower banking systems' total equity requirements, as the reduction in the equity requirement for the CDS buyer (the protection buyer) exceeds the additional equity requirements incurred by the seller. CDS premiums (spreads) serve to estimate default probabilities expected by markets and are thus a leading indicator of fears over the solvency of corporate or government borrowers. However, the direct use of CDS spreads to determine expected default rates is subject to several biases.

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