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December 2006 |
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In this issue we discuss and give insight into our CDS Valuation and Recovery Rate Model. Visit us on the web:E-Mail your suggestions and comments to: Copyright © 1996 - 2006 |
CDS Valuation & Recovery Rate Model
v
The Kynex CDS calculator now accepts a credit curve (term structure of CDS
spreads). In the very near future, you
will be able to store the credit curve for a specific credit and maintain
offsets for debt subordination level, and contract specific items such as
documentation type, settlement type, and recovery type. Therefore, you can consistently mark
multiple CDS contracts on a credit from a single term structure. You no longer need to mark every individual
CDS. You no longer need to get quotes
on contracts whose remaining life to maturity does not match any tenors for
which quotes are readily available in the market. If the term structure on a given credit
remains unchanged, you no longer need to mark these contracts, we will be
able to re-calculate the unwind value.
As the contracts age, mark-to-market will remain accurate. You
will spend less time gathering and marking CDS instruments and more time
identifying and managing your investments. For details on providing the
credit curve inputs to our calculator, please see the description of our valuation
screen. You will be able to maintain your credit curves through the Credit
Curve Maintenance Screen (and/or by ftp from a third party provider). v The calculator now accommodates the market convention of quoting to the next IMM roll date as well as on a constant maturity basis. If a tenor type of IMM roll is chosen, the calculator also quantifies your P&L on the next roll date as well as the drop in CDS spread assuming the broker does not remark the CDS on the roll. v The Kynex CDS calculator now offers an optional recovery rate model which simulates the expected relationship between CDS spreads and recovery rates. The model will also calculate the implied flat recovery rate while leaving default rates unchanged. The model can help identify potential pricing errors in the market based upon your expectations of realizable recovery rates upon default. This model is intended to address the “downturn LGD” (loss-given-default) concerns in the Basel II framework document (paragraph 468). The negative correlation between default rates and recovery rates will amplify the effects of economic cycles, and this expected behavior should not be overlooked from a risk perspective. v The Kynex CDS calculator now offers equity-linked delta and gamma estimates. These measures help estimate the impact of stock prices on the value of a CDS. They will help you with the difficult task of hedging portfolios consisting of equity derivatives (e.g. convertibles and options) and credit default swaps. Please refer to our equity-linked portfolio hedging example. v CDSs on distressed credits are now frequently quoted in terms of a running spread plus upfront points. The Kynex CDS calculator allows for such market quotes, thus saving time analyzing such contracts (an equivalent flat spread is calculated). v The economics of hedging credit spread risk with CDSs is discussed. A fixed income portfolio hedging example shows four alternatives. The profit and loss on equity-linked portfolios using CDS and a long convertible position as well as a short stock position is also examined. |
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