http://www.bloomberg.com/apps/news?pid=20601085&sid=aYgTyVZ.8T.A&refer=europe

Nothing unusual in that, but prior to this, NOKIA was a company that had CDS issued, but no debt outstanding

http://www.noelwatson.com/blog/PermaLink,guid,1bd7fe10-3b83-4e76-abc0-2e85b40483d5.aspx

I was reading this

http://www.ft.com/cms/s/0/417d0086-ee6f-11dd-b791-0000779fd2ac.html

written by (I believe)

http://belfercenter.ksg.harvard.edu/experts/875/david_richards.html

and at first I was angry at the fact that the FT had allowed such drivel to be posted, but I guess they can't be experts on every letter that is published. I posted this article in the FT Long Room

http://ftalphaville.ft.com/longroom/

to check that it wasn't just me that had these thoughts. Everyone there agreed that it was tosh. However, before I continue, I must say that I have an obvious bias as I work in the industry. Onto the letter...

Only if the rest of the market agreed with you, but what do you gain over shorting the share. Furthermore, is there a 100% correlation between the credit and equity markets?

Credit lagging

http://www.noelwatson.com/blog/PermaLink,guid,97625e8e-abff-4934-846b-74e07d785307.aspx

or leading?

http://www.noelwatson.com/blog/PermaLink,guid,6ff32223-b54c-4ac6-b1e3-6baf7d232c07.aspx

I'm sure David has the answer!

“On the other hand, if I were the US government, and had understood Mr Soros’s analysis, I could have stopped the Lehman bear raid in its tracks. When Lehman came under pressure, the US government should have entered the systemically important credit default swap market that AIG had vacated, and begun aggressive writing of credit default swaps on Lehman securities”

Assuming there was such a thing as a Lehman bear raid, the U.S. Government decided to let Lehman fail, so the decision had already been made.

http://www.irishtimes.com/newspaper/finance/2008/0916/1221430252353.html

The author is implying that the U.S. were unable to save them. AIG has so far drawn $90.3 billion from an emergency loan,

http://en.wikipedia.org/wiki/American_International_Group

"On the evening of September 16, 2008, the Federal Reserve Bank's Board of Governors announced that the Federal Reserve Bank of New York had been authorized to create a 24-month credit-liquidity facility from which AIG may draw up to $85 billion. The loan is collateralized by the assets of AIG, including its non-regulated subsidiaries and the stock of "substantially all" its regulated subsidiaries, and has an interest rate of 850 basis points over the three-month London Interbank Offered Rate (LIBOR) (i.e., LIBOR plus 8.5%). In exchange for the credit facility, the U.S. government will receive warrants for a 79.9 percent equity stake in AIG, and has the right to suspend the payment of dividends to AIG common and preferred shareholders.[1][4] The credit facility was created under the auspices of Section 13(3) of the Federal Reserve Act.[4][24][25] AIG's board of directors announced approval of the loan transaction in a press release the same day. The announcement did not comment on the issuance of a warrant for 79.9% of AIG's equity, but the AIG 8-K filing of September 18, 2008, reporting the transaction to the Securities and Exchange Commission stated that a warrant for 79.9% of AIG shares had been issued to the Board of Governors of the Federal Reserve.[26][5][1] AIG drew down US$ 28 billion of the credit-liquidity facility on September 17, 2008.[27] On September 22, 2008, AIG was officially removed from the Dow Jones Industrial Average.[28] An additional $37.8 billion loan was extended in October. As of October 24, AIG has drawn a total of $90.3 billion from the emergency loan, of a total $122.8 billion"

so I can't see why the Fed couldn't have done something similar with Lehman, if it had chosen to do so.

AIG weren’t writing protection on the single name market, as far as I am aware, so I am not sure why that was mentioned. It was writing super senior tranche protection on synthetic corporate CDOs, one of the reasons it wasn't allowed to go under

http://www.noelwatson.com/blog/PermaLink,guid,19e80fd2-0f61-4650-8afe-142458df673b.aspx

As we have seen with the ban on short selling in the UK, creating false markets (in this case by selling CDS protection) this doesn’t fix underlying the problem. False markets are not a good thing (see also Government providing mortgage payments on UK properties http://www.ft.com/cms/s/0/80b2e400-e1db-11dd-afa0-0000779fd2ac.html) , they just prolong the pain.

With its unlimited balance sheet and no requirement to put up collateral, the government could have prevented the price of Lehman credit default swaps from, as Mr Soros writes, “going though the roof"

Did Lehman spreads go through the roof?

They did gap out, but what is David proposing, that we ban CDS from reflecting what the market believes is a company's chance of defaulting? Has he any evidence that spreads widening is self fulfilling?

http://0-ftalphaville.ft.com.innopac.up.ac.za/blog/2009/01/06/50811/glencore-time-to-come-clean/

Is there smoke without fire?

http://www.noelwatson.com/blog/PermaLink,guid,38ea0de9-82a7-488c-8c2a-5cdd2f0928dc.aspx

The government could have prevented financial meltdown

By preventing ultra low interest rates, and the Greenspan put, and Clinton not encouraging people to buy a house they couldn't afford, then yes,

but by selling CDS protection on Lehman, I doubt it!

Credit default swaps, in massive quantities, are still out there and still causing havoc

Vague hysterical sentences are meaningless, unfortunately. The CDS market survived a massive shock when Lehman went under.

“Even though no organisation of consequence is now writing credit default swaps, the exorbitant prices of "marks" on them still govern accountants’ (“fair value”) pricing of bonds and, in turn, regulatory capital requirements”

So the CDS market is acting as an efficient price discovery mechanism – is this a bad thing?

The Government has discussed trade credit insurance, not writing CDS

http://www.bbc.co.uk/blogs/thereporters/robertpeston/2009/01/insurance_that_worsens_crunch.html

“If the authorities had understood the Soros analysis several years ago, and unattached credit default swaps had been banned, the credit bubble and bust would never have occurred.”
 

See my comments above. The securitization market (not plain corporate CDS) may have accentuated the boom, but policy mistakes started it

In the FT today

http://www.ft.com/cms/s/0/61c23b40-ee42-11dd-b791-0000779fd2ac.html

and the reponse on FT alphaville

I attempted an implementation of this a while back

http://www.noelwatson.com/blog/PermaLink,guid,fa4d8579-f754-48e0-a485-dc7c6850405f.aspx

http://www.bloomberg.com/apps/news?pid=20601009&sid=aLCNBJIsERKs&refer=bond

ALLX SPCD

As discussed here a couple of months ago

http://www.noelwatson.com/blog/PermaLink,guid,1e6654fa-c806-45b7-9aae-5cf7bd5376ac.aspx

there was an article in the FT yesterday (subscription required)

http://www.ft.com/cms/s/0/ea1c4920-cb12-11dd-87d7-000077b07658.html

RBS has the biggest exposure at £19.9bn

Main: 207

XOver: 1125

HiVol: 530

Main: 207

XOver: 1125

HiVol: 530

UK: 114

http://www.bloomberg.com/apps/news?pid=20601086&sid=a5PyWzGVCR7E&refer=latin_america

Main: 203

XOver: 1090

HiVol: 515

UK: 114

Main: 199

XOver: 1040

HiVol: 495

UK: 111

Main: 193

XOver: 1020

HiVol: 480

UK: 117

Main: 195

XOver: 1025

HiVol: 490

UK: 112

Tribune defaulted the other day - the CDS has been distressed for a while so it wasn't news

http://www.reuters.com/article/americasDealsNews/idUSTRE4B76FJ20081208

but I remembered that I could check the net notional

which was around $1.6 bn last month - slightly above average for a top 1000 entity, but well below the $6bn of Lehman

Main: 195

XOver: 997

HiVol: 488

UK: 114 (close)

Main: 194

XOver: 1003

HiVol: 493

UK: 116

I wrote a few weeks back about how equity had lagged credit in the current downturn

http://www.noelwatson.com/blog/PermaLink,guid,6ff32223-b54c-4ac6-b1e3-6baf7d232c07.aspx

but for certain stocks, the trend has been reversed

Alcoa

Dow Chemical

and the Dow

all fell around the end of September, but the CDS spreads have blown out a lot more recently

Seeing mid of 998. Main 193, HiVol 498

Main: 196

XOver: 1015

HiVol: 515

UK: 120 (close)

Main: 196

XOver: 1013

HiVol: 522

UK: 118

Main: 202

XOver: 1035

HiVol: 530

*New addition*

UK CDS: 125 (Friday close)

(A lot less liquid than the indices, so it may be the case that last night's closing is used - I will state when I am using this)

Main: 219

XOver: 1099

HiVol: 552

Xover widened 50bps this morning with no reported trades - very illiquid market

Seeing average mid slightly over 1100bps. If we assume a recovery of 25%, over half the names are priced to default over the next five years.

It was only on Wednesday it passed 1000bps

http://www.noelwatson.com/blog/PermaLink,guid,0d31c672-bb52-4549-9187-0e115b030bf4.aspx

Main: 205

XOver: 1017

HiVol: 510

Currently seeing 200/202

Xover still hovering around 1000bps

Main: 192

XOver: 997

HiVol: 470

Main: 195

XOver: 1020

Today was the day the XOver breached 1000bps

http://www.noelwatson.com/blog/PermaLink,guid,0d31c672-bb52-4549-9187-0e115b030bf4.aspx

and I even heard suggestions that the index be quoted on an upfront basis (as single names tend to when they hit 1000bps). When single names are quoted upfront, a percentage of the notional is paid, then 500bps paid annually (125bps per quarter). The XOver currently trades on a coupon of 560bps. 1000bps spread on XOver equates to ~13bps upfront.

Main briefly skimmed 200bps (I saw 198/200).

Seeing mid of around 1005. I recall this being predicted 18 months ago in the previous blowout

http://www.noelwatson.com/blog/PermaLink,guid,3a000888-e5df-4208-9515-01586f6332f2.aspx

My buy at 67bps is looking good (shame it is not real money!)

http://www.noelwatson.com/blog/PermaLink,guid,0c5c8ee2-cafe-4a5f-9f55-e0a0af90dc9e.aspx

EDIT: Cameron just mentioned UK CDS being worse than HSBC in the Commons

Main: 188

XOver: 954

Main: 185

XOver: 940

Main: 197

XOver: 950

From yesterday's close

http://ftalphaville.ft.com/blog/2008/12/02/18924/debt-protection-costs-hit-new-highs/

Main: 188

XOver: 936

Main: 171

XOver: 893

Heard on the grapevine

"In advance of CDS moving to a clearing house environment, ISDA and market makers have been discussing changes to the way CDS trades. One big change is the dropping of restructuring (Modified restructuring) as a credit event in US single name CDS. The reason for this is that the settlement of that credit event is complicated in respect of deliverables and would be difficult to conduct a cash settlement auction for, which is essential for the move to a clearing house. Dealers are strongly supportive of the move, while loan hedgers (who stand to lose some capital relief as some loss scenarios would not be covered by their hedge) would like to keep the restructuring provision. No changes are planned for European CDS, which will still trade with restructuring (Modified Modified restructuring)."

I had an email conversation with someone a few months back where I said that I couldn't see this happening

http://www.reuters.com/article/bondsNews/idUSN2049973920081120

Good for my fantasy portfolio

http://www.noelwatson.com/blog/PermaLink,guid,0c5c8ee2-cafe-4a5f-9f55-e0a0af90dc9e.aspx

not so good for the UK as a whole.

I previously mentioned that I was going to have a look at the CDS data that DTCC had recently published

http://www.noelwatson.com/blog/PermaLink,guid,5b8b455a-122a-4434-9c94-b207983b0a15.aspx

In the above link I had constrained myself to index constituents as I believed that the underlying single name trades would be more liquid and hence reflect more accurately credit risk (rather than technicals due to illiquidity). The DTCC data is here

http://www.dtcc.com/products/derivserv/data_table_i.php?id=table6

and attached is the spreadsheet I created

DTCCSinglenames.xls (163 KB)

A few things to note

1. The second tab shows the names I wasn't able to map to Markit - most likely due to apostrophes. Not a major deal
2. The third tab shows names that are no longer valid in Markit but still have notional outstanding. There may be a valid reason for this - I am joining on long name, and this is not unique. So for RENTOKIL INITIAL PLC, there are two entries in the Markit database (RENTKL and RNTKIL). However, Albertson's, Inc. should now be New Albertson's Inc
   - I'm not sure why this hasn't been changed in DTCC
   

But only by 1% from $57,894bn to $57,325bn

http://www.bis.org/publ/otc_hy0811.pdf

The Gross market Values have increased - I assume this is because spreads have widened dramatically in recent months and the number measures absolute MTM

Interesting to see that insurance firms are reducing their exposure

The notional hasn't reduced as much as ISDA's number

http://www.isda.org/press/press103108.html

a

I've talked about CDS spread and ratings - I thought I would have a look at the index constituents. I am going to look at the names within the on the run series of the following ITRAXX indices

http://markit.com/information/products/category/indices/itraxx/documentation/content2Paragraphs/00/document/Markit%20iTraxx%20Europe%20Series%2010%20-%20Final.pdf

http://www.indexco.com/download/Products/CDS/Markit_iTraxx_Europe_Presentation.pdf

1. Europe (125 names, 52,515,829,460 net notional)
2. XOver (50, 6,041,035,647)

Notionals can be found here

http://www.dtcc.com/products/derivserv/data_table_i.php?id=table7

(more of that in another post)

Of these 175 names, I will take those that have an S&P rating on the underlying ref ob. This leaves us with 150 names. I am getting the spreads from Markit, and use EUR/MM spread.

Looking at the BBB there are 52 in Main and 3 in XOver. Some investors are only allowed to hold IG names, so if we order by CDS spread (I will filter on companies that trade on UK exchanges), and take the top 5 order by spread descending, we get

I chose index constituents as these tend to be liquid. However, with the DTCC releasing notional numbers it may be possible to include more names (if we assume outstanding notional and liquidity are reasonably correlated). it may also be worth looking at U.S. names

IndexConstituentRatings.xls (32 KB)

EDIT: FTSE 100 closed at 4639 on 4/10/2008

Have mentioned a few times that CDS spreads are a lot quicker to react than rating agencies. I read this article a while back in Bloomberg magazine, but couldn't find it on the internet.

http://www.bloomberg.com/apps/news?pid=20601087&sid=a0tWb0sTTgu8&refer=home

follows on from similar article from DTCC

http://www.noelwatson.com/blog/PermaLink,guid,cbbb4a7a-4a20-4de9-9f1f-d458f483c938.aspx

the only thing I would point out is

"Perhaps the biggest misperception about the CDS sector is its role in today's financial crisis. The root cause of the financial sector's woes is too many bad mortgage loans. While some observers point to AIG's use of CDS as contributing to its downfall, the truth is that the company, like others, took on the risk of too many defaulting mortgages and troubled loans."

as pointed out yesterday,

http://www.noelwatson.com/blog/PermaLink,guid,19e80fd2-0f61-4650-8afe-142458df673b.aspx

AIG may be getting hit by writedowns on super senior protection on corporate bond backed CDO, in addition to all the mortgage woes. There is an article talking about AIG in the NYT today.

http://www.nytimes.com/2008/10/30/business/30aig.html

Tavakoli is mentioned, again!

now it could be the turn of corporate backed CDOs

http://ftalphaville.ft.com/blog/2008/10/23/17365/the-cdo-unwind-waiting-to-happen/

I have spoken in the past about models struggling to value AAA tranches

http://www.noelwatson.com/blog/PermaLink,guid,7a0b0ec8-475e-4359-b2a7-06dc3e46801f.aspx

and as spreads have continued to widen, this has become more difficult. Tavakoli's recently released book

http://www.amazon.co.uk/Structured-Finance-Collateralized-Debt-Obligations/dp/0470288949/ref=sr_1_1?ie=UTF8&s=books&qid=1225267106&sr=1-1

talks about the super senior tranche (pg 331)

As you can see from the above, the super senior tranche is much cheaper than AAA to issue.

For a super senior tranche of $1 billion, the capital charge would be $80million (see 8% total risk weighted assets http://en.wikipedia.org/wiki/Bank_for_International_Settlements). If the tranche pays 10bps (retained on banks books), return on regulatory capital is 1.25% (10bps/0.08). Furthermore, the Fed recognises a 20% risk weight for super senior risk, and Basel II guidelines allow AAA to  get 20% BIS risk weighted treatment, giving a 6.25% return. Banks may also be able to use model-based capital treatment, further improving returns.

Super senior tranches make up a large percentage of total CDO issuance, yet there is no standard definition of pricing super senior risk.

Monolines are one of the insurers of super senior risk, and it would appear that AIG are spending most of their loan on posting additional collateral as the spreads widen on these these tranches

The article mentions super senior - see attached

levsupseniorCDO_082205.pdf (659.25 KB)

UPDATE:

The original Bloomberg article was a bit misleading

http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a5x0jMKZf4yc

According to CreditFlux, there is ~1.5trn USD notional on synthetic CDO (CSO). So where does the

"Investors are taking losses of up to 90 percent in the $1.2 trillion market"

come from?

• If it refers to the 1.5trn being marked down by 90%, this is incorrect.

~65% of CSO volume is super senior risk - marked at 80%

25% is mezz/senior risk - marked at 40%

10% is equity - marked at 10%

This equates to a markdown around 37%, so 450bn (if we assume market size of 1.2trn and not 1.5trn). Note that this is a mark to market loss - it is unlikely that super seniors will be impaired (barring disaster), and mezzanine CSO tends to be held until maturity, so MTM is not important.

• It could be that they are referring only to the mezzanine tranches, but the notional is unlikely to be 1.2trn, and they are not all trading at 10%.
• Alternatively, it could refer to the CDS risk (leveraged around 3-4 times for mezz) of the mezzanine tranche, but assuming the ITRAXX and CDX IG have widened by around 200bps, this translates into a markdown of 8-15%, not 90%.

CDS spreads on Sovereign debt have been in the news a lot recently. There was the story about the U.S. Government being riskier than McDonald

http://ftalphaville.ft.com/blog/2008/09/26/16386/what-mcdonalds-can-teach-you-about-finance/

and with Iceland struggling, spreads in most countries have widened. I thought I would look at some of the spreads and what the market think their chances of default are. Starting with the U.S. Since the link above was written, 10 year (I will use 10 year for all sovereigns) have continued to widen
 

 
and the probability of default at ~3% in the next five years (note that I am using mid spreads and an assumed recovery of 0.4 (originally thought that all sovereigns recover at 25%, but Markit/Bloomberg show otherwise). I use this nearest roll date to five years from now, which in this case is 20/12/2013)

 
the UK is looking more risky than the U.S.

 
with >5% chance of defaulting in the next five years
 

 
Some other sovereigns, and their chance of default in next five years

• Iceland (40% recovery): 56%
• Pakistan (40% recovery): 89%
• Argentina (25% recovery): 92%

 
Bloomberg CDSW calcs here

http://www.noelwatson.com/blog/PermaLink,guid,fa4d8579-f754-48e0-a485-dc7c6850405f.aspx

Markit will be showing Sovereign CDS on the internet

http://us.ft.com/ftgateway/superpage.ft?news_id=fto102320081726108049

Now it could be that the current CDS spreads don't reflect the real risk of default

• The markets may be overreacting to the current market turmoil
• Protection sellers may be asking for extra premium for tail risk. Say for example a bank sells 10mm 5 year protection on UK for 62bps. They will receive 15.5k every quarter ((1/4)*10000000*(62/10000)), but if UK defaults, they pay out 6mm (assuming recovery of 40% and ignoring discounting for present value). This is similar to someone being asked to underwrite a £1m lottery where the chance of a payout being 1 in a million. In theory, you would say that £1 is fair value for the risk you are taking on, but how many would take on this underwriting?

I have talked about CPDOs in the past

http://www.noelwatson.com/blog/SearchView.aspx?q=CPDO

last week the very first CPDO unwound

http://ftalphaville.ft.com/blog/2008/10/17/17193/requiem-for-the-cpdo/

Note details here

http://www.financialregulator.ie/data/in_mark_prosp/4712%20FinalProspectusChess%20II.pdf

http://www.financialregulator.ie/data/in_mark_prosp/4712%20FinalProspectusChess%20II.pdf

Looks like 200ps over risk free was too good to be true. Ironically, if it were launched today when spreads are much wider, they would have less chance of blowing up

A CDPC is a special purpose entity that writes unfunded credit protection of a notional many times the amount of capital it holds. It is a ‘continuation vehicle’ in that it has no wind up date and has a counterparty rating of triple ‘A’. Capital comes in the form of equity and debt which are both subordinate to the claims of any counterparty. CDS written by a CDPC do not need to be collateralised. Estimated total notional of protection written by CDPCs is in the region of USD 100bn.

Some more info

http://www.creditflux.com/files/8490.0.aspx

"Most basically, CDPCs support effective risk transfer. By trading with triple A CDPCs, counterparties can achieve capital relief relativeto their internal economic capital models and to the regulators. In addition, credit derivative traders are exposed to Gaap mark-to-market volatility arising from their credit derivative positions. In a large, complex, opaque financial institution, a sudden negative mark-tomarket can translate into a big impact on the
stock price."

Now where have I seen that before?

http://ftalphaville.ft.com/blog/2008/10/01/16559/aig-and-an-overlevered-europe/?source=rss

Current rated CPDCs

Primus Financial Products
Athilon Asset Acceptance Corp
Invicta Capital
Cournot Financial Products
Newlands Financial
Channel Capital
Koch Financial Products
Aladdin Financial Products
Satago Financial Products
Quadrant Structured Credit Products

Athilon has recently been downgraded

http://www.marketwatch.com/news/story/fitch-downgrades-athilon-off-rating/story.aspx?guid=%7B50405484-B24D-4C36-8E3D-00B67D1E17F7%7D&dist=hppr

http://www.dtcc.com/news/press/releases/2008/tiw.php

"The payment calculations so far performed by the DTCC Trade Information Warehouse relating to the Lehman Brothers bankruptcy indicate that the net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range (in U.S. dollar equivalents)."

So a smaller value than was being banded about by the press last week

http://www.straitstimes.com/Breaking%2BNews/Money/Story/STIStory_289276.html

"Lehman CDS sellers lose US$365b"

Article in Independent

MorganStanleyFutureOfTheCDSMarket.pdf (121.7 KB)

related BIS document - central counterparties

http://www.bis.org/publ/cpss64.pdf?noframes=1

There have been a lot of people on various forums expressing surprise about the events unfolding in Iceland. Some are saying that there was no warning.

(I discussed this on another forum back in April)

http://www.pistonheads.co.uk/gassing/topic.asp?h=0&t=518561

People are upset at Martin Lewis on MoneySavingExpert

http://blog.moneysavingexpert.com/2008/04/01/icesave-how-safe-are-your-savings-facts-and-myths/

"Icesave has high interest rate accounts, and is a best buy in certain categories. That makes it an attractive account. The risk of it going bust, doesn’t seem to be very substantively more than any other top savings account bank and this is unlikely to happen (though nothing’s impossible)".

I don't agree with the above. I used to look at the CDS spreads in our flow desk blotters and the Icelandic banks (Glitnir, Kaupthing, Landsbanki) were always in the top 10 highest CDS spreads over the last year or so.

(note that I haven't included the last month's data as it compressed the y axis too much)

Compare this (Landsbanki) with Abbey (part of Santander, so they trade approximately the same CDS levels). Now I'm not sure what rate Abbey were offering at the time, but seeing a CDS spike above 800bps sets alarm bells ringing.

There has been lots of debating as to whether these spreads have been justified - they are illiquid in the CDS market (typically 850/950 bps), so hedge funds were rumoured to be pushing them wide

http://www.efinancialnews.com/assetmanagement/index/content/2450194340

http://www.moneysupermarket.com/community/forums/t/turnaround-in-icelandic-cds-levels-signals-end-of-20926.aspx

I have also read research pieces saying that there were forced protection buyers at the short end of the curve pushing the curve wider.

I am a believer that certain markets (maybe not credit) are reasonably efficient, so while the market may not be right all the time, it would be foolish to ignore them.

The same goes for the betting exchanges (Spreadfair etc) that were showing falls before the general population cottoned on.

http://www.creditfixings.com/information/affiliations/fixings/auctions/current.html

Tembec - 2nd October 2008

Fannie Mae Senior - 6th October 2008

Fannie Mae Subordinated - 6th October 2008

Freddie Mac Senior - 6th October 2008

Freddie Mac Subordinated - 6th October 2008

Lehman Brothers - 10th October 2008 (TBC)

Peston is saying the HBOS deal will go through

http://www.bbc.co.uk/blogs/thereporters/robertpeston/2008/10/insane_markets_and_hbos.html

The credit markets show

LLOY 185/200

HBOS 315/345

Which will be right?

It would appear that conservatism constitutes a credit event (apparently an article in ISDA documentation). This could be interesting.

Some useful info here,

http://www.moodys.com/moodys/cust/content/loadcontent.aspx?source=staticcontent/Free%20Pages/Credit%20Policy%20Research/CreditPolicyCurrentRsrch.htm

including corporate defaults

http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20Pages/Credit%20Policy%20Research/documents/current/2007000000474979.pdf

http://news.bbc.co.uk/1/hi/programmes/newsnight/7506653.stm

They mention the $68 trillion notional - why do people still use this number?

• S&P

http://www2.standardandpoors.com/spf/pdf/fixedincome/Final_CDOEvaluator_Slick.PDF

• Moodys

http://www.moodys.com/cust/content/Content.ashx?source=StaticContent/Free%20Pages/Products%20and%20Services/Downloadable%20Files/cdorom%20overview.pdf

• Fitch

http://www.fitchratings.com/web_content/product/FITCH_Corporate_CDO_Model_2008_Users_Guide_v1.1.pdf

 

 

http://ftalphaville.ft.com/blog/2008/05/21/13198/ft-alphaville-exclusive-moodys-error-gavetopratings-todebtproducts/

"Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower."

http://www.ft.com/cms/s/0/09a762ee-2699-11dd-9c95-000077b07658,dwp_uuid=5fd271ee-61f6-11dc-bdf6-0000779fd2ac.html

But is it as simple as a simple bug, or is their method of modelling CPDOs flawed

http://www.noelwatson.com/blog/PermaLink,guid,136d4b18-8d46-4687-8a83-0ef2f97ab805.aspx

http://www.napierscott.com/financialsearch/

Seems that equity derivatives is the new hot area

There seems to have been some confusion between various Markit indices

http://www.markit.com/information/products/category/indices.html

with some saying there is no liquidity in the indices

http://www.ft.com/cms/s/af1e1c18-ee04-11dc-a5c1-0000779fd2ac.html

"Liquidating structured credit instruments requires buying large amounts of protection using credit default swaps. This, in turn, drives the cost of protection higher, potentially triggering a chain reaction."

http://www.portfolio.com/views/blogs/market-movers/2008/03/12/how-the-cds-market-can-support-the-bond-market

"a mark to market problem and, to boot"

I am assuming that they are talking about indices, as structured credit vehicles, such as CDOs tend to hedge against these rather than single name. There are no liquidity problems on the ITRAXX Europe, Xover or HiVol, and I believe the same to be true of the CDX. Furthmore, Markit are still publishing end of day curves, so why is mark to markit a problem?

Perhaps people are getting confused between the credit and the ABX indices?

Probably not, as roll costs are only around 1bp - CPDOs will typically roll into the new index over a 10 day period. Provisional constituents are out from Markit - BAA is on the list

http://www.noelwatson.com/blog/PermaLink,guid,f5c355be-b7ad-4e93-96b1-4dee8b737444.aspx

Some more CPDO documentation...

JPMCPDO.pdf (82.85 KB)

SANDPCPDO.pdf (239.16 KB)

We are now in the strange world of buying protection from a counterparty on a name that has a lower CDS spread than the counterparty - and the counterparty doesn't have to post collateral.

Collateral posting requirements in CDS trades are typically reserved for lower credit quality counterparties in order to ensure payments are made. Because other monoline mortgage insurers – such as MBIA Insurance Corp., Ambac Assurance Corp. and Radian Asset Assurance – are AA and AAA rated, their CDS contracts are unlikely to include the provisions, said the market participant.

http://www.ft.com/cms/s/2/57f389b0-8f0d-11dc-87ee-0000779fd2ac.html

If I were to buy protection on Diageo for 5 years @ 80bps from Bear Stearns which is AAA rated and therefore doesn't have to post collateral, judging by the spreads, there is more chance of the counterparty defaulting than the reference entity.

People are starting to complain about the ABX indices and how the limited number of names mean they indices is being pushed wider than fair value due to short selling

http://www.aleablog.com/dont-mark-to-markit/#comment-828

It will be interesting to see how the CDS indices are affected

http://www.noelwatson.com/blog/PermaLink,guid,f5c355be-b7ad-4e93-96b1-4dee8b737444.aspx

On a Markit related issue, some are unhappy that Markit have a monopoly

http://www.alternet.org/story/74510/?page=entire

http://www.irdonline.com/public/showPage.html?page=331456

http://www.irdonline.com/public/showPage.html?page=339382

As someone who had to work with reference data before red codes I see Markit as a good thing

One thing I forgot to mention about Wim's talk the other evening

http://www.noelwatson.com/blog/PermaLink,guid,136d4b18-8d46-4687-8a83-0ef2f97ab805.aspx

was that he mentioned that conventional Gaussian copula models were starting to throw up some strange number in the current distressed markets. This was discussed in a Bloomberg article yesterday.

http://www.bloomberg.com/apps/news?pid=20601009&sid=aWl_spgXiGIc&refer=bond

The article is written in a rather confusing manner (in my opinion), but what it is saying is that attempting to value certain tranches of the CDX index is proving impossible (correlation greater than one) with the Gaussian model.

There is a discussion on the Wilmott forum

http://www.wilmott.com/messageview.cfm?catid=4&threadid=59608

WimLevyBC.pdf (170.21 KB)

http://www.tavakolistructuredfinance.com/press.html

http://www.bis.org/publ/quarterly.htm

DISCLAIMER: Work in progress. I used this as a way of testing the performance of C# relative to VBA

TranchePricer.zip (147.79 KB)

Spreadsheet here

http://www.noelwatson.com/blog/PermaLink,guid,297c1bf3-25b8-4d15-913d-41e9b697ce1c.aspx

http://www.nytimes.com/2008/02/17/business/17swap.html?_r=2&hp=&oref=slogin&pagewanted=all

I intended to comment on this, but forgot, and it wasn't until SeekingAlpha mentioned it that I though I'd comment on it

http://seekingalpha.com/article/65104-a-misleading-chart-on-credit-default-swaps

"Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond."

There are two problems with this. Firstly as the article points out, noone expects the recovery rate to be zero (unless it has been specified in the contract). Furthermore, it is implied the article implied that the recovery rate is 63%, when in fact BIS say the recovery was 53% (page 46)

http://www.bis.org/publ/qtrpdf/r_qt0606d.pdf

"Under certain circumstances, a shortage of
deliverable debt can drive up the price of such paper beyond the level that
might otherwise be justified by the expected size of repayment. In the case of
Delphi, the settlement price of 63.5% (and an average CDS recovery price of
53.5%) was considerably higher than the settlement prices of other firms from
the same sector or than rating agencies’ estimates of the ultimate recovery
rates on Delphi’s debt."

so, higher than typical 40% assumed recovery rate, but the 40% is a guide not a rule.

A more recent auction - recovery rate was ~40%

http://www.creditfixings.com/information/affiliations/fixings/auctions/cds-2008/cds2.html

http://uk.reuters.com/article/governmentFilingsNews/idUKN1928853020080219

Markit do good daily updates for those that don't already read them

Correction: The recovery rate for the index auction was 63.5, but the average (which would include CDOs where the valuations are performed independently) was 53.5%

http://www.securitization.net/pdf/Nomura/CDO-CDS_20Mar06.pdf

Talked about this last week

http://www.noelwatson.com/blog/PermaLink,guid,d0edfd9e-c0ab-4276-a0b5-d204829bba2a.aspx

I was worried that it would be similar to his previous lecture, but was pleasantly surprised to discover that it had been updated to include recent events.

Probably the most interesting part of the evening was the analysis of the CPDOs. Taking ABN's SURF as an example, the original version of this paid 200bps over LIBOR and was rated AAA by both S&P and Moodys. Wim's argument was that using the Gaussian copula approach does not accurately model fat tail events (the credit markets are shock driven and do not follow a normal distribution), whereas the Levy model gets a lot closer. Using the Levy process would have given a rating of A.

Also discussed were CDO index tranches (ITRAXX Europe and CDX) and how the Gaussian copula gives a base correlation smile (high correlations have to be entered for more senior tranches to get accurate spreads). Using the Levy process gets a much flatter base correlation.

The next few years will be interesting for credit risk modelling. Could it be that we will find a better way to model correlation than using one variable to model the interaction between 125 companies? Will people finally start to move away from using Gaussian models to those that model the tails more accurately? Is it a good time to launch a CPDO now that spreads are historically high?

Some Fitch analysis on the first generation CPDOs

After posting a couple of weeks ago about Wilmott and co working on a new way of valuing CDOs,

http://www.noelwatson.com/blog/PermaLink,guid,b9f877c7-6c00-441b-a520-b933493d2e8d.aspx

it seems that initial work is well underway

http://www.wilmott.com/blogs/paul/index.cfm/2008/2/25/Science-in-Finance-VI-True-Sensitivities-CDOs-and-Correlations

I am going to see if I can get involved in some way

I've ordered these from Amazon

• Credit Derivatives: Life after Copulas

http://www.amazon.co.uk/exec/obidos/ASIN/9812709495

• Credit Derivative Strategies: New Thinking on Managing Risk and Return

http://www.amazon.co.uk/exec/obidos/ASIN/1576601870

In the meantime I am rereading Tavokalis' Collateralized Debt Obligations and Structured Finance

http://www.amazon.co.uk/Collateralized-Debt-Obligations-Structured-Finance/dp/0471462209/ref=sr_1_2?ie=UTF8&s=books&qid=1204044324&sr=1-2

 - the recent subprime events make it worth a revisit!

I've already commented on this,

http://www.noelwatson.com/blog/PermaLink,guid,ca8f0369-3933-4816-a136-b850c306dab1.aspx

but an article in the Independent got me thinking how much the market will be moved in the event of one or more CPDOs unwinding

My initial thoughts were that the unwinding shouldn't move the market a great deal as if this were the case the CPDO would not be a viable product. My reasoning being that if buying large amount of an index moved the market that much, then the twice yearly index rolls, where the CPDOs sell protection on the new series and buy protection on the prior series (to net out their position from the sale six months previous), the costs would be too great. However, looking at the ABN CPDO article

SurfCPDO.pdf (755.98 KB)

they assume a roll cost of only 1bp (see page 29), with no mention of market movements due to large volumes. After some investigation this makes sense. When the CPDO managers trades with a counterparty (typically a flow desk within the same bank as the CPDO structurer) during the roll, the counterparty's net exposure does not change a great deal. They are selling 4.75 year index protection and buying 5.25 year exposure. The index constituents between the two series do not typically change a great deal meaning that the counterparty will not be dramatically changing his risk exposure.

Contrast this with a CPDO unwind where lots of credit protection is sought with no corresponding  buying, and you can see where there may be some trouble ahead. Having said that, it would be good to know how large the CPDO market is in comparison to the amount of Series 8 ITRAXX Europe/CDX issuance to see how large the potential scale of the problem may be - this article thinks $25 billion for CDX and ITRAXX

http://www.reuters.com/article/bondsNews/idUSN2827508620080228

Probably the first article out there where some proper analysis has been undertaken

BarCapCounterparty.pdf (452.09 KB)

and a summary from CreditFlux

http://www.creditflux.com/digest/2008/02/22/barclays+capital+says+cds+counterparty+failure+could+cause+47+billion+of+losses.htm

In summary, BarCap suggest that in the event of a counterparty defaulting, the losses to protection buyers are not as high as the numbers being suggested by others. However, it could be argued that BarCap may be talking up their book!

This article suggest they are

http://www.nytimes.com/2008/02/17/business/17swap.html?_r=2&dlbk&oref=slogin&oref=slogin

"But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold."

But with settlement platforms such as DTCC

http://www.dtcc.com/

having been around for a while, is this still the case. With a large percentage of dealer to dealer trades going over the IDB's (Inter dealer brokers such as Creditex), this stuff being automatically settled, and the majority of the rest of the sell side trades automatically being settled, I'm not sure where the number comes from

http://ftalphaville.ft.com/blog/2008/02/18/10980/credit-markets-beware-cpdos-on-the-cusp-of-forced-deleveraging/

Not exactly unexpected, a number of people were dubious that something rated AAA could return 200bps over risk free asset

http://alephblog.com/2008/02/22/a-small-victory-lap-on-cpdos/

There was also a very good article on Wilmott a while ago. CPDO's sell on the run protection (currently Series 8) and therefore receive a revenue stream. They are typically levered 15X - which starts to become a problem when you are marking to market in a widening market. They operate using a martingale betting system

http://en.wikipedia.org/wiki/Martingale_(betting_system)

but eventually they reach their limits - be it NAV or leverage. 18 months ago when a raft of CPDOs were launched, this glut of protections selling drove index protection down

http://www.noelwatson.com/blog/PermaLink,guid,38888779-0383-42bb-bcbb-f7f2723bc6c1.aspx

Now it appears the opposite may be happening

According to an FT article it does - apparently BAA are trying to avoid being in Series 9 of the index - due to be launched on 20th March

http://www.ft.com/cms/s/0/937f2be0-e031-11dc-8073-0000779fd2ac.html

http://uk.reuters.com/article/UK_SMALLCAPSRPT/idUKL1076761820070910

"Inclusion in the iTraxx Crossover list of mostly junk-rated European companies generally translates into a premium in a company's cost of protection on credit default swaps (CDS), which provide a kind of insurance against non-payment of corporate debt. The premium comes from the higher levels of activity for companies in the index"

Does higher activity equate to a higher spread? If there are more buyers than sellers this would be the case - one example may be when the market is volatile -  people wanting to buy credit protection tend to buy an index as it is a lot easier than buying the underlying constituents. This sends the index spread wider. If the single names didn't widen an arbitrage would now exist

http://www.noelwatson.com/blog/PermaLink,guid,edc5d058-1a2d-4e43-88a4-d58c63a9cb74.aspx

Easier to execute in theory than in practice - in volatile times, the single name spreads widen and liquidity dries up. Looking at the current XOver spread, it is hard to justify the spreads based on current levels of default (last European default was Parmalat). Hence, it could be argued that the underlying constituents have spreads that are too wide.

However, as with equities and banks having a low P/E ratio, we are taking current, not future assumptions - a lot of things could change!

Wim Schoutens is giving a lecture on credit derivatives and Levy processes at 7City next week

http://www.schoutens.be/

http://en.wikipedia.org/wiki/L%C3%A9vy_process

There is already a similar recorded lecture of his on the CQF website, but it will be good to attend in person so I can ask a few questions. If he gives some example code I will modify my work in progress spreadsheet.

http://www.noelwatson.com/blog/PermaLink,guid,b9f877c7-6c00-441b-a520-b933493d2e8d.aspx

Some of Wim's earlier Levy related work

WimExoticOptions2002.pdf (358.25 KB)

http://ftalphaville.ft.com/blog/2008/02/13/10890/systemic-risk-rises-correlation-hits-new-highs/

Not sure that this statement is correct

"That last - in current markets perhaps utterly obvious - point is worth one final tangent. In a way it cuts right to the heart of the whole subprime fiasco. How did CDO tranches get AAA ratings? Because most rating models don’t - or didn’t - have a correlation metric."

Even if it were, the addition of a correlation metric won't necessarily solve all the problems. The one factor Gaussian copula is the most widely used out there and is know to have its limitations. Wilmott and co and working on a new model - I will wait for this before modifying my spreadsheet

http://www.noelwatson.com/blog/PermaLink,guid,297c1bf3-25b8-4d15-913d-41e9b697ce1c.aspx

http://www.ft.com/cms/s/88e590f0-d4f8-11dc-9af1-0000779fd2ac.html

I mentioned this last year

http://www.noelwatson.com/blog/PermaLink,guid,1144b6b7-c207-406a-9d6f-69f9684804b9.aspx

http://www.moneyweek.com/file/41437/credit-default-swaps-how-to-spot-the-riskiest-banks.html

A good article, but with a number of things that I don't agree with. The main argument in the article is that you can compare what the bank has to pay for loans in the market (risk free + CDS spread) compared to what it pays its savers. However, this is not comparing apples with apples

• The CDS spread takes into account recovery rate - typically 40% for senior debt and 20% for subordinated. Taking HBOS which the article states has a 5 year senior spread of 70bps. One could argue why not use the subordinated spread of 130 bps, as if the banks defaults, savers will come in below even the subordinated debt holders.
• Why is the 5 year rate being used - the banks typically only lock you in for one year

http://www.alliance-leicester.co.uk/savings/index.asp?page=esaver&ct=savingshome

Alliance and Leicester 1 year subordinated is currently 310bps

Northern Rock does have a CDS spread - 5Y senior is approx. 250bps

All started by Bill Gross

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

saying that protection sellers may start to struggle if CDS companies start to default. There is around 43bn USD notional CDS outstanding

http://www.bis.org/publ/qtrpdf/r_qa0712.pdf

Even if companies do not start to default, the fact that spreads have started to widen recently indicating that the market is pricing in more defaults happening in future meaning that protection buyers will be asking for more collateral. This is where SCC came unstuck

http://www.ft.com/cms/s/0/5982ae9c-bff9-11dc-8052-0000779fd2ac.html?nclick_check=1

Some further comments here

http://ftalphaville.ft.com/blog/2008/01/14/10132/not-merely-a-subprime-crisis-cds-and-global-financial-meltdown/?source=rss

http://ftalphaville.ft.com/blog/2008/01/11/10099/counterparty-risk-08-edition-for-desking/

http://www.ft.com/cms/s/0/50d659d2-c1f3-11dc-8fba-0000779fd2ac.html

CreditOptionPricingModel.pdf (332.56 KB)

options.pdf (Deleted) (447.53 KB)

I coded this up using logic from Chaplin's excellent book

http://www.amazon.co.uk/Credit-Derivatives-Management-Trading-Investing/dp/047002416X/ref=sr_1_1/026-3520114-3646802?ie=UTF8&s=books&qid=1193910857&sr=8-1

The next step is to get this working in an enterprise application (C#) - this will speed the calculations up dramatically. I will then use real time feeds from brokers such as CreditEx to price in near real time.

Pricerv1.zip (63.47 KB)

Some references that I found useful

References.xls (16 KB)

Guide_to_Exotic_Credit_Derivatives.zip (938.86 KB)

http://ftalphaville.ft.com/blog/2007/07/30/6213/cds-report-its-a-very-brave-man-or-woman-who-calls-the-end-to-this/?source=rss

and one person thinks it may go to 1000bps

http://www.bloomberg.com/apps/news?pid=20601087&sid=a4CHnE.bPy6s&refer=home

I would be very surprised to see it go to this level - the underlying single names are currently trading around 400bps so assuming sufficient liquidity it would be possible to sell index protection and buy the underlying - however, liquidity in single name is nowhere near as high as in indices.

http://www.markit.com/marketing/press_releases.php?date=10Jul2007

A bit late to the market, with both BestQuotes

http://www.bquotes.com/

and my old company QuoteVision

http://www.quotevision.com/Home/index.php

having been around for a few years now. However, Markit will have a USP in that it holds the reference data set so will find it a lot easier to match quotes with entities.

There are 3 types of single name/indices trade

• New Deal
• Assignment
• Unwind

I covered new deals a while ago

http://www.noelwatson.com/blog/PermaLink,guid,90c9c561-95f0-46e5-a7a0-5030cdc07d60.aspx

but the logic is slightly more complex for assignments and unwinds

For single name, we have to use the following logic when calculating accrued coupon

If the original trade date is greater than a month before the last roll, we use the last roll date. If it is less than a month before the last roll date, we take the original trade date

So, taking some example, and assuming the effective date of the trade is 15/06/2007 (i.e. today is 14/06/2007)

• Original trade date is 07/05/2006

Here the trade is after the last roll (20/03/2007), so the accrued is calculated from then - 39 days

• Original trade date is 07/03/2007

The trade is within a month of the next roll date, so we assume a "long coupon" and calculate from original trade date - 100 days

• Original trade date is 07/03/2007

The trade is more than a month before the last roll date, so we calculate from the last roll date - 87 days

Indices are more simple, as you always pay the coupon from the last roll date, and all trades have a fee, as you are buying into a running contract.

I read this yesterday in the Torygraph

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/03/bcnitaly103.xml

but it wasn't until today that I had a closer look. Our application was flagging up a negative implied default rate (IDR)(arbitrage opportunity). I put together a spreadsheet to work out where the problem was (attached), and happened to notice that it was the first name that our desk trade that is trading inverted, with the 1Y spread over 100 bps. Note that almost all of the other banks have a 1Y spread of 10bps or less.

Note that I looked at IDR a while ago, but only up to 5 year

http://www.noelwatson.com/blog/PermaLink,guid,fa4d8579-f754-48e0-a485-dc7c6850405f.aspx

http://goldnews.bullionvault.com/files/Investment_Landfill.pdf

I first did this last year

http://www.noelwatson.com/blog/PermaLink,guid,5c54efd9-9b42-480a-bb1a-01386a2c9d48.aspx

but realised that I hadn't got round to updating this when I was looking into a trader's query on DV01 calcs.

Changes include:

• Using maturity date rather than term
• Allowing Notional
• Calculating time to maturity using Actual/360 with effective date being T+1

Tests

1. Maturity 20/9/2012 (5 year trade) - 100bps

Our application gives 4489 (using I.R. of 4.73%)

and BBG gives 4487

 

2. Maturity 20/09/2017 (10 year trade) - 300bps

We get  6503 (using I.R. of 4.82%)

and BBG gets 6540

So we are within 1% of BBG which is adequate

Attached is a spreadsheet that shows how the fair value of an index can be calculated. Points to note

• Recovery rate: Used for DV01 calculation. ITRAXX financial subordinated has 20% recovery constituents, ITRAXX has a mixture of senior (40%) and subordinated, and the rest are all senior
• Weight: Usually same for all constituents in an index unless a merger has taken place (i.e. Intesa Sanpaolo SpA).
• Spread: We linearally interpolate the spread if necesary. With the attached example, the S7 ITraxx 5Y XOver matures in 20/06/2012, so we have 4.75 years until maturity (we calculate from next roll date - 20/09/2007).
• Interest rate: Again, use interpolated interest rate - used for DV01 calcs
• DV01 - discussed here http://www.noelwatson.com/blog/PermaLink,guid,5c54efd9-9b42-480a-bb1a-01386a2c9d48.aspx

Credit derivatives volume still growing

http://www.isda.org/press/press041807ms2006.html

CVC's attempt to buy J Sainsbury appears to be over

http://news.independent.co.uk/business/news/article2442076.ece

with the 5Y CDS spread trading at  ~45 bps, down from its peak of ~130 bps, but still above the spread of ~25bps 6 months ago.

However, as can be seen from the chart below, the share price hasn't decreased by as much. If it mirrored the CDS spread, i would expect it to return to below £5.00.

Two things to note:

• Usually share prices and CDS spreads move in opposite directions - if a company is in trouble the shares go down as the perception is that the company is worth less and the CDS spreads increase because there is more likelihood of default. A leveraged buyout is different. The CDS spreads increase because the buyout will be financed using debt, making the company more risky, and the share price usually increase because the potential bidder tends to offer more than the market value to tempt people to buy into the offer
• In common with several other entities (Nokia being one that springs to mind), Sainsbury does not have any unsecured debt outstanding

http://ftalphaville.ft.com/blog/2007/04/11/3757/cds-report-market-awaits-cvcs-next-move-on-sainsbury/

I used to hold SBRY when it paid a good yield (around 6%) but sold it when the dividend cut was announced. If I were to attempt to make money from my above beliefs, I would either

• Go short on SBRY stock
• If I was worried about a buyout still happening (and assuming I could trade CDS as a private investor), I would buy CDS protection as a hedge.

This has been updated since the last post (note that I tried to update the original post's date but this caused Dasblog to crash - duplicate GUID)

http://www.noelwatson.com/blog/PermaLink,guid,5e315cea-4633-4924-9563-69cbfb3dfb0c.aspx

http://www.markit.com/news/Markit-LCDS-Report.pdf

Markit processed $750 million worth of trades in Q4 2006 compared to the previous quarter - I wonder how much of this increase is due to more people using the Markit platform and how much is due to the market itself growing.

There is an upcoming Loan CDS conference - I might pop along to this

The FTSE dipped below 6000 yesterday

As soon as 6000 was breached it quickly fell another 10 points before recovering later in the day

Even after the last week, FTSE volatility is still historically low (EWMA 5 day window)

Below shows the volatility of the ITRAXX Xover vs. FTSE 100 over the last few months

I haven't plotted the volatility of the main ITRAXX Europe index, but if it remains high, it will be interesting when the CPDO's come to roll on the 20th of this month.

The article below discusses the markets over the last week

http://www.ft.com/cms/s/7be783ec-cb51-11db-b436-000b5df10621.html

Citigroup

CitiGroup.zip (425.37 KB)

Credit Suisse

CreditSuisse.zip (1.23 MB)

JP Morgan

JPMorgan.zip (3.12 MB)

Merrill Part 1

MerrillPart1.zip (2.64 MB)

Merrill Part 2

MerrillPart2.zip (4.9 MB)

Nothing new in this article

http://www.bloomberg.com/apps/news?pid=20601087&sid=a9Y_CRc7oo2Y&refer=home

but I was interested to read that Etienne Gorgeon thinks that buying the bond and CDS protection (negative basis trade) means that you are immune to default. What happens if the protection seller (counterparty) cannot pay (counterparty risk). Furthermore, the CDS protection does not cover coupon payments, so if default occurs just before a coupon is due to be paid, the protection buyer misses out. There is also recovery rate risk - more significant for bonds that are priced away from par

http://www.finextra.com/fullpr.asp?id=13270

Last month's news - CDS trading continues to grow exponentially

http://www.bloomberg.com/apps/news?pid=20601087&sid=a8CXWz8PKcNs&refer=home

http://www.markit.com/news/Markit-LCDS-Report.pdf

We have reached the painful stage in our project where we are mapping Bloomberg tickers to CDS entities. As can be seen from the CDSS screenshot below, the tickers are not exactly intuitive.

For example "CAB1E5" is Abbey Senior 5 year

so you would assume that 1 equals senior, and the E5 equates to 5 year maturity, but this is not always the case. Why they couldn't use a combination of markit ticker (or red code), seniority and tier is beyond me.

Example for the above could be: ABBEYSNR5

Anyway CDSD, option 17 can be used to download all Bloomberg CDS tickers

Link to Wilmott

http://www.wilmott.com/attachments/CPDOs%20a%20primer.zip

http://www.amazon.co.uk/Frequently-Asked-Questions-Quantitative-Finance/dp/0470058269/sr=1-4/qid=1164651158/ref=sr_1_4/202-8567845-9211045?ie=UTF8&s=books

Following on from calculating DV01 using CDSW in a previous post,

http://www.noelwatson.com/blog/PermaLink,guid,fa4d8579-f754-48e0-a485-dc7c6850405f.aspx

I have been looking at using CDSW for indices. Page 14 of the following shows how an index trade is priced

http://www.indexco.com/download/Products/CDS/iTraxx.EUR.Presentation.pdf?download=20061127

To recreate the trade shown, the first thing to do is to find the ticker and series (this differs slightly from a single name search).

Type CDSI then option 11

this gives you the following selection

we are interested in the latest series (6) of ITRAXX Europe for 5 year. The series is therefore "6EU2".

After modifying the data to match the document, we get the following

Note that these values are very slightly different than the document - the interest rates are different now to when the document was written.

Some things to note:

• Quarterly payment frequencies
• Principal is approx 2* DV01 (28 bps deal vs. initial 30 bps coupon)
• Accrued of -83.3 is notional*spread*elapsed days (we are using ACT/360)

=10000000*(30/10000)*1/360

• Recovery rate is 40% - ITRAXX Europe Subordinated is 20%
• Moving the valuation date further into the future (see below) shows principal reducing (because DV01 is reducing) and accrued increasing. The accrued will increase until the 20th December when it will get reset to zero after the quarterly coupon is paid.

http://biz.yahoo.com/prnews/061114/ukm029.html?.v=4

This will help improve the problem with booking and keeping a track of credit derivative trades

http://www.noelwatson.com/blog/PermaLink,guid,5d4aafbd-ee2a-4bcc-9075-72494cbe136a.aspx

Dura (DRRA-OpCo) filed for Chapter 11 last week. I didn't think anything of this until our import job failed to complete today. The reason was that we had only catered for spreads of <100000 bps, but Dura was coming it at over 200000 bps. When a company is trading in this position I guess the protection sellers make up a number big enough so that no one takes them up on the offer (200000 bps = 2000%), and that this was an upfront spread converted into a running spread.

Senior and sub indices for Loan CDS

http://www.markit.com/markit.jsp?jsppage=announcements.jsp&id=3

This was driven from a requirement to ensure that traders couldn't enter spreads that had a negative implied default rate. For example if a 3 year CDS is priced at 50 bps and a 5  year at 60 bps, the 4 year must be between 37.5 and 75 to avoid an arbitrage -

3 * 50 = 150bps

5 * 60 = 300bps

(this example is given in Chaplin)

Obviously this was simplified example (not taking interest rates into account), so more digging was required - I found the following on Wilmott

http://www.wilmott.com/messageview.cfm?catid=4&threadid=37690

http://www.wilmott.com/messageview.cfm?catid=8&threadid=9830

and in particular, the JP paper that details how the calculation is done

http://www.wilmott.com/attachments/CDS_JPM1.zip

I got the majority of the calculations working but couldn't get from the yld to discount factor. However, looking at Moorad Chouldry's new book, it appears that he is happy to use the spot rate for his calculations, so I have done likewise, although this will mean that my results differ slightly from Bloomberg.

Taking a typical curve (ACCOR), Bloomberg CDSW (using JPMorgan model), gives the following

The things to note here are:

• Using EUR swap curve
• Quarterly calculation/payments
• Fees accrued on ACT/360 basis
• Recovery of 40%

TODO: Bootstrap swap curve

So for the 5 year default, we are showing 0.028 compared to 0.0276

We can also use the spreadsheet to calculate DV01

although we differ from Bloomberg's figure of 4678.

UPDATE: The 4678 figure is wrong - I hadn't adjusted the deal spread from default of 100 bps.

Note that my original calculation

http://www.noelwatson.com/blog/PermaLink,guid,5c54efd9-9b42-480a-bb1a-01386a2c9d48.aspx

gives a DV01 of 4484, so this is more accurate - close but no cigar.

However, the spreadsheet enables us to check for negative default rate. For example, if we multiply the two year spread by 10, we can see that the probability of default is higher at two years than at three. This would lead to an arbitrage situation (I would sell you two year protection and buy three year protection), so should be flagged.

Attachment: Spreadsheet (note that the 2 year spread has the x10 value)

CDSWv1.xls (40.5 KB)

• Credit Derivatives by Geoff Chaplin (Page 97) http://www.amazon.co.uk/exec/obidos/ASIN/047002416X/qid=1141718528/sr=1-1/ref=sr_1_2_1/026-0058056-7028455

• Moorad Choudry: The Credit Default Swap Basis (Page 160)

http://www.amazon.co.uk/Credit-Default-Swap-Basis/dp/1576602362/sr=1-1/qid=1162898932/ref=sr_1_1/026-8787779-9446068?ie=UTF8&s=books

It appears that Blue Mountain assumed that Cablecom Luxembourg S.C.A. (CABCOL) would cancel their debt but instead issued more debt.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aAGLLFzoxbXY&refer=home

http://www.ft.com/cms/s/93c88c4e-6ae0-11db-83d9-0000779e2340.html

http://www.ft.com/cms/s/f9a56cea-6adf-11db-83d9-0000779e2340.html

Blue Mountain were one of the first people to use QuoteVision - the company I used to work for

http://www.creditma.com/clients.aspx

One of the F.T. articles states

"However, for a CDS contract to be valid, it needs to be backed up by some tangible bonds in the marketplace (even if far smaller in size). Usually, that is not a problem, since few companies are debt free. But if corporate events occur which prompt a company to withdraw its bonds - such as a merger - this can suddenly make CDS contracts worthless"

Interesting, as companies such as Nokia do not have bonds outstanding, yet have CDS traded on them. I remember this happening with Sainsburys last year. I believe there is a CDS market as traders are trading on the assumption that there will be bonds issued at some point in the future, so are creating a market in anticipation

Janet Tavaloki is quoted in the other FT article - her two books

http://www.amazon.co.uk/Collateralized-Debt-Obligations-Structured-Finance/dp/0471462209/sr=8-1/qid=1162552071/ref=sr_1_1/026-8787779-9446068?ie=UTF8&s=books

http://www.amazon.co.uk/Credit-Derivatives-Synthetic-Structures-Applications/dp/047141266X/sr=8-2/qid=1162552071/ref=sr_1_2/026-8787779-9446068?ie=UTF8&s=books

 give other examples of where there has been contractual disputes in the past - one example being the Nomura and CSFB case

http://www.credit-deriv.com/crenewsjan03.htm#nomura_wins

• CPDO and indices

I read about the CPDO product from ABN a few months ago on Wilmott

http://www.wilmott.com/messageview.cfm?catid=3&threadid=41740

and this type of product is said to be driving indices spreads below fair value

http://ftalphaville.ft.com/blog/2006/11/01/555/daily-report-credit-default-swaps-6/

• CDS futures on CME

The Chicago Mercantile Exchange are launching CDS futures

http://www.financialnews-us.com/?page=ushome&contentid=1045700409

http://www.ft.com/cms/s/635fc7c8-3ea0-11db-b4de-0000779e2340.html

http://www.wilmott.com/messageview.cfm?catid=3&threadid=39346

I read this blog article last night

http://wallstreettechdaily.com/2006/10/25/does-technology-takes-the-out-of-bond-trading/

and the article on the Globe

http://www.theglobeandmail.com/servlet/story/LAC.20061025.RBONDS25/TPStory/Business

about how bond salesmen and traders are making less money due to technology advances. This is inevitable with all asset classes as they mature and I have witnessed this first hand in the CDS market

Originally, CDS spreads were sent out from the sell side to buy side over Bloomberg and it was very hard to work out who was offering what spread due to overload of information until quote parsers were introduced

http://www.creditma.com/

Before this some traders were getting 1000's of emails a day, each containing several quotes with each sell side, with each sell side having proprietary tickers for each entity. Even with these parsers, it was still hard to match entities as there was no uniform way of matching names to reference entities until Markit introduced RED Codes

http://www.markit.com/marketing/

Around 2 years ago, I noticed the first non-integer spreads being quoted - a sure sign that the spreads were tightening.

However, we are still at the point now where without products such as QuoteVision, it is difficult to find out what the market is doing intraday, as Markit spreads are currently end of day (they are currently testing an intra-day quote parser).  The market is still growing for these parsers, although I believe once Markit release their intra-day parser that integrates with their comprehensive reference database, it will be game over for the competition.

There are lots of trading platforms springing up, such as CreditEx

http://www.creditex.com/web/index.html

although these tend to be intra-broker, so don't help the buy side narrow their spreads, and some are index only, so don't allow single name trades.

Lectured by Satyajit Das

http://www.euromoneytraining.com/default.asp?Page=16&cc=44&productid=4043&SearchStr=

this course talks about CDS, CDO and Structured Credit. Das is the author of two books I recently read

• Credit Derivatives: CDOs and Structured Credit Products:

http://www.amazon.co.uk/Credit-Derivatives-CDOs-Structured-Products/dp/0470821590/ref=pd_bxgy_b_img_a/026-8787779-9446068?ie=UTF8

and

• Traders Guns and Money

http://www.noelwatson.com/blog/PermaLink,guid,aeb31b5c-de3b-4d09-9a5c-00673d202154.aspx

http://www.bloomberg.com/apps/news?pid=20601103&sid=adbsVAhN68TM&refer=us

Markit page here (can't work out how to find spread - different layout to CDS)

http://www.markit.com/magnoliaPublic/affiliations/abx

Similar to the credit derivative link

http://www.noelwatson.com/blog/PermaLink,guid,87315086-469d-4d8e-894c-9d0793c93fc3.aspx

I thought I would add a list off Credit derivative books that I own - this will be a work in progress (the list will be in chronological order of when I purchased them from Amazon).

For the books I use frequently I have added or will add a review, and I will link to them from here.

• The Credit Default Swap Basis: Moorad Choudry

http://www.amazon.co.uk/Credit-Default-Swap-Basis/dp/1576602362/sr=8-1/qid=1160645606/ref=sr_1_1/026-8787779-9446068?ie=UTF8&s=books

• Applied Derivatives: Markets, Valuation, Risk Management: Robert E Whaley

http://www.amazon.co.uk/Applied-Derivatives-Markets-Valuation-Management/dp/0471786322/sr=8-4/qid=1160635158/ref=sr_1_4/202-5458939-5705418?ie=UTF8&s=books

• Structured Credit Products: Credit Derivatives and Synthetic Securitisation: Moorad Choudhry

http://www.amazon.co.uk/Structured-Credit-Products-Derivatives-Securitisation/dp/0470821191/sr=1-2/qid=1160635434/ref=sr_1_2/202-5458939-5705418?ie=UTF8&s=books

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,254c5d7e-fb73-4d19-9fe3-815c14d2955b.aspx

• Credit Derivatives: CDOs and Structured Credit Products: Satyajit Das

http://www.amazon.co.uk/Credit-Derivatives-CDOs-Structured-Products/dp/0470821590/ref=pd_bxgy_b_img_a/026-8787779-9446068?ie=UTF8

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,254c5d7e-fb73-4d19-9fe3-815c14d2955b.aspx

• The Credit Market Handbook: Advanced Modeling Issues: H. Gifford Fong

http://www.amazon.co.uk/exec/obidos/ASIN/0471778621/026-8787779-9446068?%5Fencoding=UTF8

• Active Credit Portfolio Management: A Practical Guide to Credit Risk Management Strategies: Jochen Felsenheimer

http://www.amazon.co.uk/exec/obidos/ASIN/3527501983/026-8787779-9446068?%5Fencoding=UTF8

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,c4fa6029-44b9-4ba6-bb69-b6e0236f1e5a.aspx

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,20de1cad-79af-41b0-a513-48298b5d1d77.aspx

Review: http://www.noelwatson.com/blog/PermaLink,guid,f4c74c59-c315-4f07-a5c4-67a5928d10b7.aspx

• Credit Derivatives and Synthetic Structures: A Guide to Instruments and Applications: Janet M. Tavakoli

http://www.amazon.co.uk/exec/obidos/ASIN/047141266X/026-8787779-9446068?%5Fencoding=UTF8

• Collateralized Debt Obligations and Structured Finance: New Developments in Cash and Synthetic Securitization: Janet M. Tavakoli

http://www.amazon.co.uk/exec/obidos/ASIN/0471462209/026-8787779-9446068?%5Fencoding=UTF8

• An Introduction to Credit Risk Modeling

http://www.amazon.co.uk/exec/obidos/ASIN/158488326X/026-8787779-9446068?%5Fencoding=UTF8

• Credit Derivatives: Risk Management, Trading and Investing

http://www.amazon.co.uk/exec/obidos/ASIN/047002416X/026-8787779-9446068?%5Fencoding=UTF8

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,254c5d7e-fb73-4d19-9fe3-815c14d2955b.aspx

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,291085b3-206f-4248-9688-20dafb3b6ef8.aspx

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,5c54efd9-9b42-480a-bb1a-01386a2c9d48.aspx

• Credit Derivatives: Application, Pricing, and Risk Management: Gunter Meissner

http://www.amazon.co.uk/exec/obidos/ASIN/1405126760/026-8787779-9446068?%5Fencoding=UTF8

Referenced: http://www.noelwatson.com/blog/PermaLink,guid,a5cd0517-0d1c-41e6-9bfc-f379327afb93.aspx

I commented on this a while ago

http://www.noelwatson.com/blog/PermaLink,guid,7d9b7d5b-7f9f-4746-8236-aa1f6174e240.aspx

F.T. had a few articles on this yesterday

http://msnbc.msn.com/id/14990001/

http://www.theaustralian.news.com.au/story/0,20867,20474805-36375,00.html

Terri Duhon (quoted in 2nd article) runs B&B Structured Finance

http://www.bandbstructuredfinance.com/about.html

 and part of their offering is training courses - I was on one of these while at CMA

My client has tasked me with implementing CDS basis functionality for the traders, so I thought I would jot down what is required.

The CDS basis is defined as the CDS Spread minus the Asset Swap Spread/Z Spread - the result is usually positive, although this is not always the case.

If the basis is sufficiently positive, a trader could enter into the following trades:

• Borrow and sell the underlying bond (easier said than done), investing the proceeds of the short position.
• Sell protection on the reference entity

The CDS fee would be greater than the spread on the asset swap leading to a profit

Conversely if the basis is sufficiently negative, the trader could

• Purchase the underlying bond (by repo or money market borrowings)
• Purchase CDS protection.

The spread on the asset swap is greater than the payment for CDS protection, so again a profit is made

There are several things that drive the basis, including

Positive basis:

• Credit events: All CDS contracts with restructuring types except XR (no restructuring) would be triggered by a restructuring credit event

Negative basis:

• Counterparty risk: The protection buyer runs the risk that the protection seller will not/can not pay up when the reference entity defaults.

To look at CDS basis on Bloomberg, type in the corporate ticker, the coupon and the maturity. Next tap the "Corporate" key and "CRVD". Shown below is British American Tobacco.

The following screen will then be shown

Here we can see that there are five reference bonds, and the basis is negative.

The programmatic side isn't too difficult either.

Firstly, we must work out which bonds relate to a given entity. My client is fortunate enough to have access to Markit, so can use the reference red obligations to look up the underlying bonds. Once we have these ISIN's we can look up the Bloomberg IssuerID. From here we can look up all bonds with the same issuerID, tier and currency as the cds we are looking at. 

Next, we must find the CDS spread value, which is the five year spread minus the interpolated spread value.

Taking the first bond (02/25/09) as an example, we would do the following

• Calculate time to maturity

= Maturity - next roll date

= 25/02/2009 - 20/09/2006 = 2.4 years

• Calculate spread at term above and below

      Assuming 2 year spread is 9 bps and 3 year is 14 bps, this would give

      9 + (((2.4 - 2)/(3-2))* (14 - 9))

=11 bps

• Next get the ASW/Z Spread - in this case we have 17 bps

= 11-17

=-6bps

References:

• http://www.amazon.co.uk/Credit-Derivatives-CDOs-Structured-Products/dp/0470821590/sr=8-2/qid=1158603159/ref=sr_1_2/026-8787779-9446068?ie=UTF8&s=gateway

Pages 459-488

• http://www.amazon.co.uk/Credit-Derivatives-Management-Trading-Investing/dp/047002416X/ref=pd_bxgy_w_h__text_b/026-8787779-9446068?ie=UTF8

Chapter 11

• http://www.amazon.co.uk/Structured-Credit-Products-Derivatives-Securitisation/dp/0470821191/sr=8-1/qid=1158603159/ref=sr_1_1/026-8787779-9446068?ie=UTF8&s=gateway

Chapter 8

 

Choudry has another book out soon on CDS basis

http://www.amazon.co.uk/gp/product/1576602362/ref=wl_it_dp/026-8787779-9446068?ie=UTF8&coliid=I2UP6EDODZ3A89&colid=187F0UOF8NJGT

I've written about GM and their chances of defaulting a few times.

http://www.noelwatson.com/blog/PermaLink,guid,7f056791-b34d-4d40-9554-ad772079878f.aspx

http://www.noelwatson.com/blog/PermaLink,guid,49d6809c-0c1b-4dc4-8e4e-d15ad9acb209.aspx

http://www.noelwatson.com/blog/PermaLink,guid,a5cd0517-0d1c-41e6-9bfc-f379327afb93.aspx

However, it seems like things could be turning around - it will be interesting to see whether a tie up with Nissan and Renault occurs

http://www.bloomberg.com/apps/news?pid=20601087&sid=aywBCTuUnDFg&refer=worldwide_news

GM appear frequently on Markit's daily email for greatest credit improvement, and the 5 year CDS is now around 700bps, almost half of what it was at the peak.

http://www.bloomberg.com/media/markets/toc.pdf

http://www.bloomberg.com/media/markets/kiesel.pdf

Some good CDS related info in this month. I picked one up from Finsbury Square

http://maps.google.co.uk/maps?f=q&hl=en&q=EC2A+1PQ&ie=UTF8&ll=51.520019,-0.086185&spn=0.004747,0.013475&t=h&om=1

Reading this report today highlighted problems that a lot of the banks are having with booking Credit Derivatives trades.

http://www.finextra.com/fullstory.asp?id=15377

http://www.isda.org/c_and_a/pdf/ISDA-Operations-Survey-2006.pdf

CDS are an OTC product, and as such there will always be problems identifying the entity that the trade is being made on. My client has the luxury of having full access to the Markit database, but there are still problems:

Potential entity identifiers include

• Markit Red Code: This does not cover all traded CDS. In there are around 3900 entities, of which around 3600 are valid (i.e. underlying reference obligation has not changed in any way). Of these 3600, 200 do not have redcodes, so another identifier has to be found.

Note that for indices, Markit always supply a redcode, both for the index itself and for the underlying constituents.

• Name: This name is not unique (i.e. there are two Rentokils), although it is (currently) unique for valid CDS
• Markit Ticker: This is unique but is not industry standard

Of course there is an additional problem when your bank is trading an entity that is not in the Markit database. Or when you think the entity is not in the Markit database, so you use an alternative name, but in fact the entity was in Markit all along.

After adding a type field to our entity table today I filtered on all "Sovereign" CDS and was surprised to find there was CDS issued on IRAQ. The underlying bond is XS0240295575. Unsurprisingly of the ~100 sovereign CDS, it has the highest spread of around 420 bps for 5 year. Jamaica was second.

There are numerous vendors offering different types of CDS data. Below are my findings so far (note that this is a work in progress)

Links:

http://www.creditmag.com/public/showPage.html?page=314658

I've been reading through these and although they don't present anything groundbreaking, this is the kind of thing that can be automated at minimal cost and give the trader more opportunities and ideas.

https://www.markit.com/marketing/news/case_study_portal_citigroup.pdf

https://www.markit.com/marketing/news/case_study_portal_creditsuisse.pdf

http://www.amazon.co.uk/exec/obidos/ASIN/3527501983/026-0058056-7028455

I've read a number of Credit Derivative books and have learnt the following when looking at what to buy

• Get a recent book - It used to be the case that I would wait until a book had some reviews on Amazon before shelling out. With the rapidly evolving CDS market, this is impossible.
• You can't go wrong with Wiley.

This book was published in December 2005 and since I received it in January 2006 has been a constant reference. It has been the only book I've read that gives strategies currently used by traders, and replaces Chaplin as my previous favourite

http://www.amazon.co.uk/exec/obidos/ASIN/047002416X/qid=1142612078/sr=1-1/ref=sr_1_2_1/026-0058056-7028455

This strategy looks for anomalies between an index and its constituent names. For this example, I will be concentrating on the ITRAXX indices

http://www.indexco.com/data/IndexMap.asp?menu=data&s=0&opa=505&index=menu8 (registration required)

There are several reasons why the index may not be trading in line with the underlying entities, one being whether the market outlook is bullish or bearish. If the outlook is bullish the skew (difference between actual index spread and average of constituent entities) will shrink (and maybe become negative) as investors look to increase their credit exposure by selling protection.

If the index price appears too high compared to the underlying, an investor can sell protection and sell on the underlying. This will only make sense on a small index (e.g. autos - 10 constituents) to keep transaction costs to a minimum.

Simply taking an average of the spreads is not the most accurate way of arriving at the theoretical index spread for the following reasons

• Dispersion bias

If you take a simple index comprising 2 entities, one trading at 200bps and the other at 300bps. The chances of the 300bps entity defaulting is higher, so the hazard rate must be taken into account. This gives a spread of 249.6 bps.
Note that this isn’t too much of  a problem when the spreads are tight, however if one name were to gap out, the difference would be significant

• Maturity mismatch

CDS contracts roll over quarterly (20th of March, June, September and December) whereas ITRAXX rolls over every six months (20th March and September). A solution to this is to use interpolation using the 3 and 5 year points.

e.g. When a 5 year ITRAXX contract is 3 months old, we would be looking for a CDS contract with 4.75 years. We can either use linear or polynomial interpolation.

• Quotation bias

ITRAXX indices trade at a fixed spread. If someone wishes to buy sell protection on an index, they will have to pay an upfront premium. The upfront value must be converted into a conventional spread.

Some information about upfront calculations can be found here

http://www.noelwatson.com/blog/PermaLink,guid,49d6809c-0c1b-4dc4-8e4e-d15ad9acb209.aspx

These values can add up to as much as 20bp difference from the simple average shown above for the 10Y iTRAXX Crossover index

References:

DJITraxx: Credit at its best

http://www.nuclearphynance.com/User%20Files/464/DJ%20iTraxx-%20Credits%20at%20its%20best.pdf

Attachment

For entities that trade both senior and subordinated debt – typically financials, there exists the potential to exploit mispricings.

The hazard rate depends on entity and not seniority, so in theory

PSen/PSub = (1-RSen)/(1-RSub)

Assuming Bank A has the following

Senior: 30 bps
Subordinated :60bps

Senior Recovery: 40%
Junior Recovery: 20%

(40% and 20% are industry standard recovery rates – these values differ in practice).

Substituting values into the equation

PSen/60 = (1-0.4)/(1-0.2)

Theoretical PSen = 45bps

Our calculations indicate that senior debt should be trading at 45bps and not 60bps - we would therefore sell senior protection and buy junior protection.

Assuming we sell £10mm notional of senior protection, we would buy 10/(1-RSen)/(1-RSub) = £13.3mm of junior protection.

Our cashflow would be £10mm x 60bps - £13.3mm x 30bps = £20000 p.a.

This does not take into account the fact that financing subordinated debt may be more expensive than pricing senior debt.

More accurate recovery rates can be found on Markit

www.markit.com

References

• Credit Derivatives by Geoff Chaplin (Page 119) - link below

http://www.amazon.co.uk/exec/obidos/ASIN/047002416X/qid=1141718528/sr=1-1/ref=sr_1_2_1/026-0058056-7028455

This type of trade aims to generate profits via a positive spread carry.

It relies on the credit curve remaining stable – so is therefore suited to higher rated entities.

You will be taking on counterparty risk when you buy protection – what’s the risk of them not paying up if the entity defaults?

Assuming you receive the curve for a given entity. The five year point is used for trading as it is the most liquid

Taking the 2 year as an example. The DV01 ratio between the 2 and 5 year is 2.05. We would therefore buy 2.05 x £10mm = £20.5mm. Every quarter, we would pay out £49090 and receive £50000 - a carry of just under £1000.

In the above example, buying the 2 and 3 year is the only time that this strategy would work. If the ratio of the spread is smaller than the DV01 ratio, credit protection should be bought and vice versa. 

Of course this example is a simplification. Issues include

• Liquidity of the various terms
• Has the trader already got too much exposure for a given term
• Bid/Ask spread on offer from the sell side. Receiving prices from more than one broker can reduce this - there are several third party tools that can provide this in near real-time

http://www.bquotes.com/ 

This type of calculation can be performed by a computer. End of day prices can be pulled from Markit (only provide mid prices at present)

http://www.markit.com/marketing/

and all entities processed to search for opportunities.

References:

• Active Credit Portfolio Management Page 475

http://www.amazon.co.uk/exec/obidos/ASIN/3527501983/026-0058056-7028455

• DV01 Calculation

http://www.noelwatson.com/blog/PermaLink,guid,5c54efd9-9b42-480a-bb1a-01386a2c9d48.aspx

Attached file:

Read this in John Mauldlin's "Outside the Box" newsletter

http://investorsinsight.com/otb_va.aspx?EditionID=285

I'm not convinced that it is inevitable that GM are going to default. The 1 year price hasn't shifted much since I looked at the end of November, and I still reckon there is less than a 1 in 4 chance of them defaulting over the next year. Maybe the author is assuming that there is bad news still to come.

Dana is another matter - 1 year is trading over 3500bps.

http://biz.yahoo.com/ap/060302/dana_finances.html?.v=2

DV01 is the sensitivity to a shift in the curve of 1 bp

Assuming the spread and interest rate curves are reasonably flat, the formula is

DV01=(1-exp(-(r+h)*t))/(r+h)

where h (hazard rate)=(spread/(1-recovery))*365/360

Taking GM

http://www.noelwatson.com/blog/PermaLink,guid,a5cd0517-0d1c-41e6-9bfc-f379327afb93.aspx

Term = 5

Spread = 1440bp

Interest rate = 4.6%

http://www.treas.gov/offices/domestic-finance/debt-management/interest-rate/yield.html

Recovery Rate = 39%

This gives a DV01 of 2.66. Multiply this value by a typical contract of 10mm gives us a value of 2666 ($/£/Euros)

DV01.zip (1.58 KB)

References

Credit Derivatives by Geoff Chaplin (Page 90) - link below

http://www.amazon.co.uk/exec/obidos/ASIN/047002416X/qid=1140112811/sr=8-1/ref=sr_8_xs_ap_i1_xgl/026-0058056-7028455

http://www.wilmottmag.com/messageview.cfm?catid=8&threadid=18242

An article in The Times this morning drew my attention

http://business.timesonline.co.uk/article/0,,9063-1974207,00.html

A junior CDO trader has been suspended for overstating his position by £30mm. It would be interesting

a). To see what type of CDO he was trading

b). To learn how he got away with it for 2 months - how did he circumnavigate the risk and P+L procedures.

http://news.bbc.co.uk/1/hi/business/4586308.stm

I reckon that the CDS traders have already priced this in, so will be interested to see how the U.S. markets react when they open

Not unexpected

http://quote.bloomberg.com/apps/news?pid=10000006&sid=aZT9AQUuEREk&refer=home

http://www.ccnmatthews.com/news/releases/show.jsp?action=showRelease&searchText=false&showText=all&actionFor=572993

If you'd sold protection that matured on the 20th Decemeber (one of the quarterly rollovers) it might've been helpful if they had waited for a day!!

Following on from my observation on the likelihood of GM defaulting, I thought I would have a crack at calculating how an upfront payment is converted into a conventional spread

When a CDS goes upfront, rather than pay a premium of x bps a year for a period of x years, the buyer of protection pays a percentage of the notional with a running spread of 500 bps per year. So, to calculate the spread for a 5 year GM CDS (USD, MM)

If we take the non-upfront calculations

The spreads are as follows

1Y 16%

2Y 15%

3Y 14%

4Y 13.5% (Interpolated)

5Y 13%

Firstly work out the present value (PV) of these premiums (I have assumed a flat interest rate of 4%) - for year 1 it is 96.15%

Next find the chances of the company continuing - note that that we use the actual spread for each term rather than the 5 year spread.

i.e for Year 1, a spread of 1600bps gives a default chance of 0.22 and therefore the chance of continuing is 0.78

http://www.noelwatson.com/blog/PermaLink,guid,a5cd0517-0d1c-41e6-9bfc-f379327afb93.aspx

We can then multiply these values to arrive at our predicted cash flow

1300*0.9615*0.7849 = 981bps

Giving a total premium over the five years of 3136 bps

Doing the same for the upfront values gives us the following

Giving a premium of 1206bps

Subtracting one from the other gives an upfront value of 19%. Note that I have based my calculations on mid prices, so this would typically trade at 18/20.

 Attached file:

I’ve been following GM’s progress over the last six months, and I thought I would have a look at what the market thinks they will do over the next year

Firstly, looking at a simple pricing model for Credit Default Swaps (CDS) - the risk-neutral probability of default using a binomial model

γ₀= s₀/((1+r₀+s₀)*(1-RR))

where

s₀ = CDS premium

r₀ = Interest rates

RR = Recovery rate

Some assumptions:

• Interest rates are constant (not far off – U.S. interest rates are 4% and the curve is pretty flat),
• The CDS premium is constant over the year (curve is pretty flat, but slightly inverted).

Using

s0 = 1400bps (USD, MR restructuring)

r₀ = 4%

RR = 38%

Gives a value of 19.1%, so this tells us that in (simplified theory), the markets believe that GM has around a 1 in 5 chance of defaulting within the year.

This number seems very high - historical data suggests that the chance of a BB rated bond is around 1.3% and B around 6.6%

The article below investigates why that may be the case

http://www.bis.org/publ/qtrpdf/r_qt0312e.pdf

References:

Credit Derivatives  - Gunter Meissner - Page 104

http://www.amazon.co.uk/exec/obidos/ASIN/1405126760/qid=1144335586/sr=1-1/ref=sr_1_0_1/203-2251018-4885533

Attached spreadsheet:

A Synthetic Forward Debt Obligation (SFDO) is a form of Collateralized Debt Obligation (CDO). It allows an investor to sell protection starting at a set point in the future (the protection seller is of the belief that the longer term spread is too high in relation to the short term).

http://www.wholesale.abnamro.com/wholesale/docs/news/12092005_SFDO.jsp

On Saturday Delphi did what many expected and filed for bankrupty protection. The 5 year was around 2000bps (some market makers quoting upfront) last week.

http://www.markit.com/markit.jsp?jsppage=commentary.jsp&id=1

It will be interesting to see the affect this has on the CDO/CDS spreads - the US market is closed for Columbus holiday today

http://today.reuters.com/investing/financeArticle.aspx?type=bondsNews&storyID=URI:urn:newsml:reuters.com:20051010:MTFH25998_2005-10-10_10-38-12_L10502606:1

1. Definition:

In a default swap (DS), also called a credit default swap (CDS), the buyer makes a periodic or an upfront payment to the seller of the default swap. The default swap seller promises to make a payment in the event of default of a reference obligation, which is usually a bond or a loan.

• Simplified example.

Bank A buys £10 mm of protection for 5 years on General Motors (GMAC) at 100 basis points per year from Hedge fund B. GMAC defaults after 1 year. The Bank delivers a bond (cheapest to deliver) to the Hedge fund. The hedge fund pays £10mm to the bank.

2. Seniority:

There are 3 main seniorities/tiers (ignoring Loan CDS)

SECDOM- Secured Debt (Corporate/Financial) or Domestic Currency Sovereign Debt (Gvt)
SNRFOR- Senior Unsecured Debt (Corporate/Financial), Foreign Currency Sovereign Debt (Gvt)
SUBLT2- Subordinated or Lower Tier2 Debt (Banks)

SNRFOR and SUBLT2 are the most actively traded. A subordinated CDS will trade on a higher spread as the recovery rate is lower.

3. Default

ISDA specifies six possible events

1. Bankruptcy
2. Failure to pay
3. Obligation acceleration
4. Obligation default
5. Repudiation
6. Restructuring

A CDS can have four different types of restructuring

1. No restructuring (XR) Unusual
2. Original restructuring (CR) US until 2001, EU until 2003/2004)
3. Modified Restructuring (MR) US 2001-2004
4. Modified Modified restructuring (MM) EU and US 2004-

The credit spreads should satisfy the relationship CR>MM>MR>XR

4. Recovery rate

Typically, a CDS desk assumes a recovery rate of 40%. However, recovery rate depends on a number of factors.

• Sector: In 2003 the average recovery rate for the Utility Gas sector was 48%, whereas for Technology it was 9.4%
• Economic cycle: Recovery rates fall during recession
• Seniority: In 2003 Senior bonds had an average recovery rate of 44.4% whereas subordinated bonds had 29.2 (value weighted)

5. Reference entity

Markit identify around 6200 reference entities, with Markit RED covering around 6000 of these, and 5700 being valid (not superceded etc.

6.  Indices

The Dow Jones CDX and ITraxx indices are the de facto benchmark for credit investors. These are examples of Collateralized Debt Obligations (CDO’s). There are several indexes within each e.g DJ North America High Yield Index and ITraxx Europe. Each index consists of a basket of reference entities e.g. ITraxx Europe consists of 125 European entities. A new series of indices is issued every 6 months (March and September) and the underlying reference entities are reconstituted. Investing in indices is slightly different to a single name CDS investment in as trading is executed at a fixed rate (e.g ITraxx Europe 5Y Series 6 is 20 b.p.s.). If the fair market value differs from this as time progresses, and upfront premium is incurred.
Markit publishes red codes for indices.
The DJ ITraxx and CDX are also actively traded in tranching structure. In the case of ITraxx Europe, the most exposed tranche (equity) is liable for the first 0-3% of losses. The most senior tranche is liable for losses from 12-22%. Tranches in between are known as mezzanine tranches. The equity tranche is usually quoted with an upfront spread, and all tranches are quoted with a correlation.
Falling correlation increases spreads for subordinated tranches and decreases spreads for senior tranches.

7. Upfront

The majority of CDS trade with a premium of <500 with the 1 year spread being less than the 5 year. However, for distressed companies, the opposite happens, with 1 year premium reaching as high as 4000 bps – the curve becomes inverted. When this happens, the spread is sometimes quoted as a percentage + 500 bps running, when the protection buyer pays a percentage of the notional upfront followed by the usual running spread.

Below are some links I have gathered over the past few weeks.

• JP Morgan powerpoint presentation talking discussing the various restructuring definitions

http://www.isda.org/c_and_a/ppt/FINAL-ISDA-PRMIA07Jan0703seminar.ppt

•   Lehman Bros documents describing credit derivatives

http://www.investinginbonds.com/assets/files/LehmanCredDerivs.pdf

http://www.investinginbonds.com/assets/files/LehmanExoticCredDerivs.pdf

• Document describing how to price a CDS using risk-neutral theory

http://www.skora.com/default.pdf

• Paper discussing how restructuring type affects spread

http://www.bis.org/publ/qtrpdf/r_qt0503h.pdf

• JP Morgan paper discussing credit derivatives in emerging markets

http://www.math.columbia.edu/~smirnov/Finkelstein.ppt

• CDS pricing calculator

http://www.derivativesmodels.com/FDX/CreditDerivatives.htm#defaultswap

• Paper examing how reduced form modelling equates to real world CDS prices

http://www.patrickhouweling.com/files/cds.pdf

• Credit pricing models

http://www.vcallc.com/mailings/additions/cdsspreads.htm

• 2 parter from John Hull

http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf
http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw2.pdf

• Document discussing why spreads are wider than they should be given probability of default

http://www.bis.org/publ/qtrpdf/r_qt0312e.pdf

• MarkIT talk about CDS Indices

http://www.markit.com/news/2005%2008%20CDS%20Index%20Primer%20-%20Final.pdf

• Credit magazine discussing correlation the effect on CDO tranches

http://db.riskwaters.com/public/showPage.html?page=168572

• Discussion on index tranches and credit risk correlation

http://www.bis.org/publ/qtrpdf/r_qt0503g.pdf

• Bear Stearns: Valuing CDO Tranches using base correlations

http://www.wilmott.com/attachments/BearSterns_Base.zip

• Probability of default as a function of correlation

http://www.fma.org/Chicago/Papers/Daglish_Li140105.pdf

• Paper discussing why there are pricing discrepancies between USD and JPY CDS spreads

http://www.math.ethz.ch/~ehlers/FX_CreditSpreads.pdf

• Lehman Brothers paper discussing implied correlation in CDO tranches

http://www.columbia.edu/~rm586/pub/Impliedcorrelation.pdf

• Merrill Lynch Credit Derivate Handbook 2003

http://www.cema.edu.ar/conferencias/download/CDS20.8.pdf

• Zurcher Kantonalbank - Danilo Zanetti - Introduction to Credit Derivatives

http://www.isb.unizh.ch/studium/courses05/pdf/3342_lecture_7.pdf

• Lehmen Brothers: Correlation and Tail Risk for CDO Tranches

http://db.riskwaters.com/global/events/im_cdotraining2005/precourse_cdos/QCRQ_Tuning_Correlations.pdf

• Nomura CDO/CDS weekly update

Note: For this you can either subscribe or modify the URL (it comes out every Monday)

http://www.securitization.net/pdf/Nomura/CDO-CDS_14Aug06.pdf

• Credit Default Swap prices as Risk Indicators of large German banks

http://www.efmaefm.org/efma2005/papers/72-duellmann_paper.pdf

• JP Morgan - Par Credit Default Swap Approximation from Default Probabilities

This is used on Bloomberg CDSW screen

http://www.wilmott.com/attachments/CDS_JPM1.zip

• HVB Indices paper - examining DJ ITRAXX and pricing from underlying constituents

http://www.nuclearphynance.com/User%20Files/464/DJ%20iTraxx-%20Credits%20at%20its%20best.pdf

• Riskmetrics:Measuring Risk on Credit Indices

Similar to the above HVB paper

http://www.math.ethz.ch/Finance/CoursesTalks/FingerPaper20060518.pdf

• Pricing tranches on CDO and CDS Indices

http://www.pstat.ucsb.edu/research/papers/2006mid/workshop_DW7.pdf

• JP Morgan: Credit Derivatives 2004 Introduction to Credit Derivatives

http://www.wilmott.com/attachments/CDConference2004_Credit_Derivatives_101.zip

I have spent the last couple of weeks reading a couple of books on Credit derivatives. This market is moving very quickly, so I bought the most recent that I could find that had reviews either on UK or US Amazon.

I was impressed with both although I have forgotten a lot of Maths since my degree days.

http://www.amazon.co.uk/exec/obidos/ASIN/1405126760/qid=1127486152/sr=1-2/ref=sr_1_2_2/202-0617262-3706237

http://www.amazon.co.uk/exec/obidos/ASIN/047002416X/qid=1127486191/sr=1-9/ref=sr_1_2_9/202-0617262-3706237