Charting a Course Through the CDS Big Bang

by Johan Beumee of FitchSolutions,
Damiano Brigo of FitchSolutions,
Gareth Stoyle of FitchSolutions, and
Daniel Schiemert of FitchSolutions

April 7, 2009

Abstract: Following the recent introduction of new forms of Credit Default Swap (CDS) contracts expressed as upfront payments plus a fixed coupon, this note examines the methodology suggested by Barclays Capital, Goldman Sachs, JPMorgan, Markit (BGJM)/ISDA (2009), for conversion of CDS quotes between upfront and running. The proposed flat hazard rate (FHR) conversion method is to be understood as a rule-of-thumb single-contract quoting mechanism rather than as a modelling device. For example, a hypothetical investor who would put the FHR converted running spreads into her old running CDS library would strip wrong hazard rates, inconsistent with those coming directly from the quoted term structure of upfronts.

This new methodology appears mostly as a device to transit the market towards adoption of the new upfront CDS as direct trading products while maintaining a semblance of running quotes for investors who may be suffering the transition. We caution though that:

• the conversion done with proper hazard rates consistent across term would produce different results;
• the quantities involved in the conversion should not be used as modelling tools anywhere; and
• for highly distressed names with a high upfront paid by the protection buyer, the conversion to running spreads fails unless, as we propose, a third recovery scenario of 0% is added to the suggested 20% and 40%.

This paper is not meant as a criticism of the proposed standardization of the conversion method but as a warning on the confusion this may generate when the method is not used carefully.

JEL Classification: G13.

Keywords: Credit Default Swap, Upfront CDS, Running CDS, CDS conversion, Recovery Rate.

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Related reading: ISDA CDS Standard Model