Credit Derivatives
Derivatives instruments on Credit component on Corporate and Sovereign
Types of Credit Derivatives
- Credit Default Swap
- Credit Default Index
- Total Return Swap
- Credit Linked Note
- Credit Swaption
Trade Information
- Trade Date
- Maturity Date
- Credit Name
- Trade Rate (Fixed or Floating)
Market Data Needed:
- Credit Default Curve
- Credit Index Price
- FX spot if the trade is not in USD
- Credit Volatility
- Bond Price
- Correlation between Credit Name vs FX , Credit vs IR
Valuation of Credit Default Swap
Mock Trade Information: Selling USD Credit Default Swap(CDS) on Mexico for 1 year and resetting quarterly.
Mock Market Data:
USD risk free interest rate curve
Mexico CDS curve
Valuation of Credit Default Swap(CDS):
Cumulative probability default is calculated from CDS curve using Recovery Rate.
Non Cumulative probability = Current cumulative PD – Previous cumulative PD
Survival Probability Default = 1- Cumulative Probability Default.
Riskless DF = Derived from USD risk free interest rate curve
Risky DF = Riskless DF * Survival PD
Riskless DF and Time are calculated same as vanilla interest rate swap.
Sell CDS NPV = Premium Leg PV – Default Leg PV
Premium Leg PV = Notional * Premium Rate * Risky DF * Time
Default Leg PV = Notional * (1 – RR) * Time * Risky DF * Non-Cumulative PD
Credit Default Swap Risks
USD Risk Free Interest Rate curve – PV01 – one basis point change in USD interest curve on each bucket impact on NPV
Credit Default Spread (CDS) Curve – CS01 – One basis point change in CDS curve impact on NPV
Recovery Rate – Change in recovery rate impact on NPV
Even though the CDS is on Mexico name but denominated in USD. There is no foreign exchange risk in this CDS trade