CDS risk profile is majorly driven by credit spreads of the reference entity. Means that change in value, MTM , of an CDS trade can be explained by the change in spreads. Interest rate movement has very limited impact on CDS valuation and it become lesser when spread widens. A seller of protection has similar economic exposure to a bondholder (they are both “long” credit) as parties are adversely affected by spread widening. The opposite is true for the protection buyer.
CS01- It is the impact of a 1 basis-point increase in credit spreads on the value of the transaction. CS01 will be negative for the protection seller as seller will be long on credit risk. CS01 will be positive for the the protection buyer as buyer will be short on credit risk.
For example , if CS01 for protection seller is −$10 K. In other words, the protection seller would lose $10 K if reference entity's credit spread widened from 100 to 101 bps. However there will be some “convexity” associated with the credit-spread risk.
If the CDS spread widens from 100 to 200 bps, this 100 bps widening will result in a <10mm decrease in the transaction’s market value for protection seller, which is somewhat less than 100 times the CS01.
CS01 can be calculated by bumping the credit spread curve of the reference entity.
Parallel CS01-
This is calculated by pricing the CDS using its quoted spread then bumping the quoted spread by 1bps and recalculating the price; the difference is the (parallel) CS01. This number is reported by Markit, Bloomberg etc.
Bucketed CS01 -
There is no universally accepted definition of bucketed CS01. Below is one of the method to calculate the bucketed CS01.
Traditionally, these numbers, like other sensitivities in the credit world, have been calculated
by forward finite difference: Each market rate is bumped in turn by one basis point; a new yield
curve is bootstrapped; and finally the CDS is repriced from the new yield curve (the credit curve
remains unchanged). The difference in price is the bucketed IR01. If the rates are bumped in
parallel this is the parallel IR01.
Calculation methodology has been explained in The Pricing and Risk Management of Credit
This is calculated by pricing the CDS using its quoted spread then bumping the quoted spread by 1bps and recalculating the price; the difference is the (parallel) CS01. This number is reported by Markit, Bloomberg etc.
Bucketed CS01 -
There is no universally accepted definition of bucketed CS01. Below is one of the method to calculate the bucketed CS01.
- For a target CDS, choose a set of maturities (pillars) that you want to measure sensitivity to (these could be the standard liquid points of 6M, 1Y, 3Y, 5Y, 7Y and 10Y).
- Set the spreads at these points equal to the quoted spread of the target CDS.
- Build a credit curve from the pillar CDSs assuming the spreads are par spreads. Price the target CDS from this curve.
- Bump each spread in turn by 1bps, build a credit curve and price the target CDS from this new curve.
- The differences from the original price are the bucketed CS01s.
Traditionally, these numbers, like other sensitivities in the credit world, have been calculated
by forward finite difference: Each market rate is bumped in turn by one basis point; a new yield
curve is bootstrapped; and finally the CDS is repriced from the new yield curve (the credit curve
remains unchanged). The difference in price is the bucketed IR01. If the rates are bumped in
parallel this is the parallel IR01.
Hi Sandal
ReplyDeleteDo you have anything that explains how the CDS_bond basis widening risk can be captured through a sensitivity measure.