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  Issue 19 | Archive May 2014

Filling A Gap In Market Data ¨C New CDS-Equivalent Physical Par Spread

In the second half of this year, the Credit Research Initiative (CRI) will be publishing daily updated credit default swap (CDS)-equivalent physical spreads with term structures from one month to five years. These will be available on www.rmicri.org in addition to the daily updated probabilities of default (PD) that have been available since 2010.

To understand what is meant by CDS-equivalent physical spreads, we start from one of the most important financial product innovations in recent decades, the CDS. CDS were created in the 1990s as a way for investors to protect themselves from defaults hitting bonds or loans that they hold in their portfolio.

At its most fundamental level, the CDS is analogous to an insurance contract: a CDS insures the holder of the contract against a corporate default of the firm referenced by the contract. In exchange, the holder pays premiums at set dates to the writer of the CDS. The CDS spread is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the nominal value. CDS contracts are conventionally quoted using a par spread, which is the spread that makes the present value of a CDS trade to be zero and eliminates the necessity of any up-front payment. As the CDS par spread reflects the market view of credit risk associated with holding bonds of the reference entity, they can be used for credit risk benchmarking.

Although the CDS market amounted to more than $13 trillion notional in 2013, there were only about 600 corporate CDS with sufficient liquidity to rely upon for credit risk benchmarking. To overcome this difficulty one can use the CDS-equivalent physical par spread, which is the hypothetical CDS par spread that would be charged if market participants were risk-neutral and there was no possibility for the CDS counterparty to default. This CDS-equivalent physical par spread can be calculated from the term-structure of PD for the reference entity, which allows the CRI to compute these spreads on an on-going basis for the close to 35,000 exchange listed firms that the CRI already computes PD for.

The concept of the CDS-equivalent physical par spread was recently introduced by Prof. Duan Jin-Chuan, the Director of RMI and the Cycle & Carriage Professor of Finance at NUS. His recent research paper entitled ˇ°CDS-Equivalent Physical Spread and Empirical Pricing of CDS by Decompositionˇ± provides a theoretical foundation and a numerical example of how the term structure of physical PDs can be used on a daily and real-time basis to compute CDS-equivalent par spreads.

This approach uses standard ISDA specifications of CDS contracts, and is calculated to the precision of a calendar day as the basic time unit. In addition, Mergers and Acquisitions are taken into consideration. On the CRI website, users will be able to choose the recovery rate applied to each reference entity. Possible applications include the empirical pricing of CDS to identify over- and under-valued CDS spreads, and use of this measure in credit risk management for a much larger set of firms that do not have CDS traded on them.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)