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1 A Primer on Credit Default Swaps 1
Credit Risk and Credit Derivatives 2
Credit Events 4
Credit Derivative Instruments 5
Introduction 5
Funded and Unfunded Contracts 6
Credit Default Swaps 8
Structure 8
CDS Coupon Dates 10
Asset Swaps 13
Description 13
The CDS iTraxx Index 15
CDS Price Quotes 21
Settlement 21
Contract Settlement Options 22
Market Requirements 24
CDS Valuation 25
Pricing Methodology Based on Reduced-Form Model Approach 26
Market Pricing Approach 30
2 Bond Spreads and Relative Value 37
Bond Spreads 37
Swap Spread and Treasury Spread 38
Asset-Swap Spread 40
Z-Spread 41
The Asset-Swap CDS Price 45
Asset-Swap Pricing 45
Asset-Swap Pricing Example 49
Pricing Differentials 50
Illustration Using the BLOOMBERG PROFESSIONAL® Service 51
Cash-CDS Basis 56
E X P A N D E D C O N T E N T S
CHART: BLOOMBERG L.P.
3 The CDS Basis I:
The Relationship Between Cash and
Synthetic Credit Markets 59
The Market Differential 60
The Credit Default Swap Basis 61
Factors Behind the Basis 65
Technical Factors 66
Market Factors 71
The Basis Smile 73
The Dynamics of the Default Swap Basis 74
Positive and Negative Basis Situations 74
Market Observation of the Basis Trend 75
The iTraxx Index Basis 78
The Index Spread 79
Market Observation 82
The Impact of the Basis on Trading Strategy 84
Summary 86
4 Supply and Demand and the
Credit Default Swap Basis 89
Supply and Demand 89
CDS Mechanics 92
A Different Basis Measure 94
5 The CDS Basis II:
Further Analysis of the Cash and
Synthetic Credit Market Differential 97
Basis and Relative Value 97
Basis Spread Measures 98
ASW Spread 99
Z-Spread 100
Critique of the Z-Spread 100
Adjusted Z-Spread 101
Analyzing the Basis 101
Simplifi ed Approach 101
Pricing the Basis 104
General Pricing Framework 104
CHART: BLOOMBERG L.P.
Adjusted Basis Calculation 107
Illustration 111
Market Observation 111
Summary 113
6 Trading the CDS Basis:
Illustrating Positive and Negative Basis
Arbitrage Trades 115
Relative Value and Trading the Basis 116
Factors Infl uencing the Basis Package 118
Measuring the Basis 118
The Hedge Construction 122
Hedging and Risk 124
Trade Examples 125
Positive Basis Trade 125
Position After 1 Month 131
Negative Basis Trade 132
Position After 1 Month 135
Conclusion 140
APPENDIX I Description of Bloomberg Screen CDSW 145
Calculating the Default Probability Curve 145
Calculating an Implied Issuer Par Coupon Curve
(the “Risky Curve”) 146
Liquidity Premium 146
Issuer Spread-to-Fair Value 147
APPENDIX II The Market Approach to CDS Pricing 149
Default Probabilities 150
Pricing a CDS Contract 157
Example Calculation 160
APPENDIX III Market-Implied Timing of Default from
CDS Prices 167
GLOSSARY 173
INDEX 189
CFA INSTITUTE PROFESSIONAL DEVELOPMENT
QUALIFIED ACTIVITY (7 hours) 195
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