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Using FINCAD XLs Single Asset Credit Default Swap Functions and Compare with Bloomberg CDS Valuations
What is a credit default swap? A credit default swap (CDS) is a contract that provides protection against credit loss on an underlying reference asset as a result of a specific credit event. A credit event is usually a default of the asset issuer or, possibly, a credit downgrade. The reference asset may be a bond, a loan, a trade receivable, or some other type of liability. The buyer of a default swap pays a premium to the writer or seller in exchange for the right to receive a payment should a credit event occur. In essence, the buyer is purchasing insurance. Using FINCAD XL to Value a CDS (Single Asset) A single asset credit default swap, where the asset is any asset that has a fixed principal and the default swap protects this principal, can be valued by using the CDS (Single Asset) workbook. This workbook can be found by clicking on the FINCAD XL menu -> Workbooks (user data) -> Credit Derivatives (CDS & Options) -> CDS (Single Asset). To download the latest trial version of FINCAD XL, visit www.fincad.com.
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If a user-defined default probability curve is used, the user can enter the curve in the Default Probability/Density Curve table:
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Deriving a Bloomberg CDS value in FINCAD XL The following Bloomberg CDS valuation will be used as the benchmark valuation.
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First Cpn
Date of Next to Last Coupon (optional) Note: If the date generation method selected in Bloomberg is backward, only enter the date of next to last coupon. Notional Principal Amount Premium Coupon Rate (in %) Premium Payment Frequency Type of Premium Accrued Interest Premium: pay accrued interest upon default pay no accrued interest upon default Accrual Method Business Day Convention Default Probability Curve (see Table 2) Note: Default probability source (set this switch to use calculated probabilities) Interpolation Method of Probability Curve Recovery Rate Payoff Type (if the pay accrued argument in Bloomberg is set to True use pay at default) Holidays
Last Cpn
Notional Deal Spread (in bps) Payment Frequency Pay Accrued: True False Day Count (from deal information section) Business Day Adj
Recovery Rate
Discount Factor Curve (risk free) Note: Discount Factor Curve can be generated on the Zero Curve tab. Select the curve that is used in the Spreads section of the CDSW screen. Use the appropriate rates for the curve (i.e. Ask, Bid, or Mid Curve). Interpolation Method
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FINCAD XL Value Date Par Default Swap Spread Table Note: Table with the following column headings (effective date, maturity date, CDS par spread, type of accrued interest payment, recovery rate) Premium Payment Frequency Accrual Method Business Day Convention Discount Factor Curve Note: Note: Discount Factor Curve can be generated on the Zero Curve tab. Select the curve that is used in the Spreads section of the CDSW screen. Use the appropriate rates for the curve (i.e. Ask, Bid, or Mid Curve). Interpolation Method Time Points (in years) at which Default Probabilities are Forecasted Interpolation Method of Probability Curve Holiday List
There is a related function aaCredit_DS_SPV01, which calculates PV01 (basis point value) based on the details of the CDS and a par default swap spread table. The PV01 value found on the Probability Calculator tab can be used to replicate the Sprd DV01 value in the Calculator section of the CDSW screen. Steps to valuing a CDS To value a credit default swap we first start with our market data assumptions. We need to calculate a risk-free curve, which can be done using the Fincad function aaSwap_crv2 using quoted deposit, futures, and/or par swap rates. The CDS (Single Asset) workbook has a tab called Zero Curve, which can be used to automate this process.
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time length (in years) 0.5 1 2 3 4 5 7 10 9.0 10.0 19.0 27.0 35.5 44.0 54.0 66.0
recovery rate 39.67% 39.67% 39.67% 39.67% 39.67% 39.67% 39.67% 39.67%
For the quotes above, we would first convert them into a format that conforms to the input 'par default swap spread table' as shown below: effective date 12-Jan-2005 12-Jan-2005 12-Jan-2005 12-Jan-2005 12-Jan-2005 12-Jan-2005 12-Jan-2005 12-Jan-2005 maturity date 12-Jul-2005 12-Jan-2006 12-Jan-2007 12-Jan-2008 12-Jan-2009 12-Jan-2010 12-Jan-2012 12-Jan-2015 CDS par spread 0.090% 0.100% 0.190% 0.270% 0.355% 0.440% 0.540% 0.660% type of accrued interest payment 2 2 2 2 2 2 2 2 recovery rate 0.3967 0.3967 0.3967 0.3967 0.3967 0.3967 0.3967 0.3967
Now the risk free curve (discount factor curve) and the converted quotes from the par default swap spread information can be used to calculate a default probability curve with aaCredit_DfltProb_DSSprd as shown below: term in years 0.5 1 2 3 4 5 7 10 probability value 0.00074962 0.001680293 0.006426048 0.013784084 0.024254484 0.037729359 0.064679621 0.112688918 curve accrual actual/360
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Additional functions for Single Asset Credit Default Swaps FINCAD has over 60 functions related to various credit derivatives including basket credit default swaps, total return swaps, spreads, and many utility functions. Below is a listing of additional functions related to Single Asset Credit Default Swaps. The following functions use the methodology shown in Hull J. and A. White, "Valuing Credit Default Swaps I, No Counterparty Default Risk", The Journal of Derivatives, 8 (1), (Fall 2000), p. 29-40. Calculating the expected payoff based on the probability of default aaCredit_Dpayoff aaCredit_Dpayoff_bin aaCredit_Dpayoff_bin_crv aaCredit_Dpayoff_crv aaCredit_Dpayoff_fs aaCredit_Dpayoff_fs_crv Calculate fair value for the payoff of a default swap on a bond Calculate fair value for the payoff of a binary default swap using a discount factor curve Calculate fair value for the payoff of a binary default swap using a discount factor curve Calculate fair value for the payoff of a default swap on a bond using a discount factor curve Calculate fair value for the payoff of a default swap on a user-defined loan Calculate fair value for the payoff of a default swap on a user-defined loan using a discount factor curve
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Calculating Spreads aaCredit_Dswap_bin_spread aaCredit_Dswap_bin_spread_crv aaCredit_Dswap_spread Calculate the spread (premium rate) of a binary default swap on a bond Calculate the spread (premium rate) of a binary default swap on a bond swap using a discount factor curve Calculate the spread (premium rate) of a default swap on a bond
Calculating Swaps aaCredit_Dswap aaCredit_Dswap_bin aaCredit_Dswap_bin_crv aaCredit_Dswap_bin_fs aaCredit_Dswap_bin_fs_crv aaCredit_Dswap_crv aaCredit_Dswap_fs aaCredit_Dswap_fs_crv aaCredit_Dswap_spread_crv Calculate the fair value of a default swap on a bond Calculate the fair value of a binary default swap on a bond Calculate the fair value of a binary default swap on a bond swap using a discount factor curve Calculate the fair value of a binary default swap on a loan Calculate the fair value of a binary default swap on a loan swap using a discount factor curve Calculate the fair value of a default swap on a bond swap using a discount factor curve Calculate the fair value of a default swap on a user-defined loan Calculate the fair value of a default swap on a user-defined loan swap using a discount factor curve Calculate the spread (premium rate) of a default swap on a bond swap using a discount factor curve
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