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March 2005 Issue

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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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March 2005 Issue


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aaCredit_DS is the function that is used in this workbook to value a single asset CDS. In using this workbook, the user has the option of utilizing a user-defined default probability curve or a calculated default probability curve. The user can choose the default probability curve to be used by setting the default probability source switch to either use user input probabilities or use calculated probabilities:

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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If a calculated default probability curve is used to value the CDS, the default probability curve can be calculated on the Probability Curve tab by using aaCredit_DfltProb_DSSprd. This function will generate a default probability curve for a given par default swap spread curve.

Deriving a Bloomberg CDS value in FINCAD XL The following Bloomberg CDS valuation will be used as the benchmark valuation.

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March 2005 Issue


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Listed below is FINCAD XLs CDS valuation using the inputs provided from the Bloomberg screen: The Bloomberg valuation can be replicated by using the CDS (Single Asset) workbook. The first screenshot from the Swap Calculator tab in the CDS (Single Asset) workbook displays the inputs from the Deal Information section and the Calculator section of the Bloomberg screen. The second screenshot from the Probability Calculator tab illustrates how the par default swap spread curve input parameters from the Spreads section of the Bloomberg screen can be used to generate a default probability curve.

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When a user uses FINCAD XL to generate a valuation that is comparable to Bloombergs valuation the user should use the following tables as a guide for entering arguments in FINCAD XL as compared to Bloomberg for a CDS valuation. Table 1: Swap Calculator Tab Inputs (aaCredit_DS) FINCAD XL Value Date Effective Date Terminating Date Date of First Coupon (optional) Note: If the date generation method selected in Bloomberg is backward, do not enter the date of the first coupon. Bloomberg Valuation Date (from Calculator section) Effective Date Maturity Date

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

Business Days (from Deal Information section)

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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March 2005 Issue


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Trade Position: (1 for a long position, 2 for a short position) Calculation Type: Simplified calculation method Trade Position is set by selecting B for Buy (equivalent to a long osition) or S for Sell (equivalent for a short position). Model Type: JPMorgan

Table 2: Default Probability Curve (Probability Calculator tab: aaCredit_DfltProb_DSSprd)

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

Bloomberg Valuation Date (from Calculator section)

Recovery Rate (from Spreads section)

Frequency (from Spreads section) Day Count (from Spreads section)

Business Days (from the Deal Information tab)

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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Then given a series of quoted par default quotes (see example above), we can create a table for input into the aaCredit_DfltProb_DSSprd function.

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

CDS par spread in bps

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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The default probability curve can then be used to generate the CDS valuation on the Swap Calculator tab.

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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March 2005 Issue


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Calculating the premium by calculating the fair value of the stream of coupons paid for the protection. aaCredit_Dpremium aaCredit_Dpremium_crv aaCredit_Dpremium_fs aaCredit_Dpremium_fs_crv Calculate the fair value for premium payments of a default swap Calculate the fair value for premium payments of a default swap using a discount factor curve Calculate the fair value for free-style premium payments of a default swap Calculate the fair value for free-style premium payments of a default swap using a discount factor curve

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

Disclaimer Your use of the information in this article is at your own risk. The information in this article is provided on an "as is" basis and without any representation, obligation, or warranty from FINCAD of any kind, whether express or implied. We hope that such information will assist you, but it should not be used or relied upon as a substitute for your own independent research. Copyright 2005 FinancialCAD Corporation. All rights reserved. FinancialCAD and FINCAD are registered trademarks of FinancialCAD Corporation. Other trademarks are the property of their respective holders. This email is for informational purposes only. FinancialCAD MAKES NO WARRANTIES, EXPRESSED OR IMPLIED, IN THIS SUMMARY.

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