Documente Academic
Documente Profesional
Documente Cultură
Bjorn Flesaker
Quantitative Finance Research Group
Bloomberg
PRMIA NY Credit Risk Forum
1 Overview
LCDS
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2 LOAN MARKET BACKGROUND
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2 LOAN MARKET BACKGROUND
Historically held by banks, but increasingly by CLOs, hedge funds, and other
institutional investors
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3 LCDS
3 LCDS
Market has developed over the last 3-4 years, with increased liquidity coming
from standardization of ISDA documents and introduction of indices (Markit
LevX and Markit LCDX)
LCDS refers to deliverable instrument; credit events are per reference name,
but the deliverable obligation is restricted to speci…c loans
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3 LCDS
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4 MODELING LCDS TERMINATION
Can be highly relevant for LCDS valuation (especially under European docs)
Research from Citigroup (2007) showed 45% of BB+ rated loans redeemed
after 5 years - much lower prepayment rates for lower rated borrowers
... but note that current market conditions are very di¤erent
Broadly speaking: loan prepayment is good news for issuer credit quality
Market value of an LCDS is given by the di¤erence between market spread and
contract spread times risky annuity value
Risky annuity value depends on interest rates, default risk, and cancellation risk
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5 ASIDE - WHY ARE WE MODELING LCDS?
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5 ASIDE - WHY ARE WE MODELING LCDS?
OTC swap market quotes are clean and simple for new trades
The Bloomberg function CDSW serves this role for the regular CDS market,
and is now being updated to include "…xing swap curves"
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6 A (VERY) SIMPLE LCDS MODEL
We will seek to make minimal changes to the market standard CDS model.
Fix a name and let t denote the time varying risk neutral hazard rate of
its default process of the underlying name, such that the ncumulative odefault
Rt
probability up to time t can be expressed as t = 1 exp 0 u du .
Z T Rt Z T Rt
ST Pte 0 u du dt = (1 R) Pt te 0 u du dt (1)
0 0
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6 A (VERY) SIMPLE LCDS MODEL
For case 1, treat LCDS as a regular amortizing CDS with an amortization factor
given by qt
For case 2, treat LCDS default leg as for a regular CDS, but use the sum t + qt
to reduce the expected outstanding notional to value the premium leg
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6 A (VERY) SIMPLE LCDS MODEL
We have the constraint on the relationship between the default and termination
probabilities that t + (1 )qt 1.
max [ T + qT 1; 0]
1 (2)
qT
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6 A (VERY) SIMPLE LCDS MODEL
For given schedules of t and qt along with the dependence parameter , the
loan recovery rate RL, we obtain the theoretical replacement LCDS spread
for maturity t as follows, making use of the continuous premium payment
approximation:
R R
(1 RL) 0t Pu u exp f 0u v dvg (1 qu) du
St = Rt Ru (3)
0 Pu exp f 0 v dvg (1 qu) du
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7 CALIBRATION AND EXTENSIONS
For LCDS, we also need the termination probabilities and the weight .