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Keeping Up With Credit in FINCAD® XL Version 9

This article explores the the significant improvements FINCAD has made to its credit derivatives offering in Version 9.

To explore the extended credit derivatives offering in Version 9, contact a FINCAD Representative and download the latest trial version of FINCAD Analytics.

More Comprehensive Credit Coverage

The growth of the credit derivatives market continues to surpass forecasts, leading to further standardization in models, assumptions and new instrument structures. The additions to FINCAD XL Version 9 enable a credit derivatives professional to now work with most of the instruments and asset classes in the credit derivatives market:

  • single entity Credit Default Swaps
  • basket CDSs
  • CDS options
  • credit default index swaps
  • credit default index swap options
  • total return swaps
  • fixed and floating rate credit-linked notes
  • rating sensitive notes
  • credit spread options and credit forwards
  • asset swaps
  • default probability estimation
  • CDS on synthetic CDO tranches, including standard and bespoke tranches, valued with Monte Carlo simulation
  • CDO tranche-linked fixed rate notes valued with Monte Carlo simulation
  • CDS on synthetic CDO tranches, including standard and bespoke tranches, valued with the fast Fourier transform (FFT) method
  • Base correlation calibration

Download a brochure on our complete credit derivatives offering.

New coverage in Version 9:

New coverage in Version 9, includes :

  1. Credit default index swap (CDIS)
  2. Credit default index swap option
  3. Comprehensive coverage of synthetic collateralized debt obligations (CDOs)

1. Credit default index swaps (CDIS)

A CDIS is a CDS on a portfolio of entities, or more specifically, on a portfolio of single entity CDSs. It can be seen as an extension of a CDS on a single entity to a portfolio of entities. Like a single entity CDS it has a payoff leg (also known as a default leg, a protection leg or a floating leg) that depends on the reference loss, and a premium leg that has a fixed coupon rate. The basic difference is that in a CDS the notional is fixed during the life of the CDS and the protection buyer is compensated at most once, while in a CDIS the premium notional is variable.

Whenever a default in the portfolio occurs, the protection buyer gets compensated by the lost amount and the CDIS continues with its premium notional being reduced by the lost amount of the defaulted entity. The most popular CDISs are the so-called standardized CDISs. In these standardized contracts the reference entity pool is homogeneous, that is, all the reference entities have the same notional and the same recovery rate. Typical examples of standardized CDISs are the CDX index series and the ITRAXX index series.

FINCAD provides tools to calculate fair values and risk statistics of CDISs. The required default data can be flat for all reference entities or different for different entities.

2. Credit default index swap options

A credit default (CD) index swap option, also known as a CD index swaption, or a CDS index option, is an option to buy or sell the underlying CDIS at a specified date. A payer swaption gives the holder of the option the right to buy protection (pay premium) and a receiver swaption gives the holder of the option the right to sell protection (receive premium).

This basic definition of a CD index swaption is similar to that of a CDS option, an option on a single-entity CDS. However, a CD index swaption is significantly different from a CDS option. In the case of an option on a single-entity, if the reference entity defaults before the option's expiry, the option will be knocked out and becomes worthless. For an option on a CDIS, when a reference entity defaults before the option's expiry, the loss will be paid by the protection seller to the protection buyer when the option is exercised. Even if there is only one entity in the portfolio, a CD index swaption is still different from a single-entity CDS option: if the entity defaults before the option's expiry, the option's seller will pay to the protection buyer the lost amount at expiry. Clearly, a CD index swaption is always more valuable than a single-entity CDS option.

Another fundamental difference between a CD index swaption and a CD swaption is that the former has a fixed premium rate and a strike spread while the latter has only a fixed premium rate. The strike spread is used to calculate an upfront cash settlement amount of the underlying CDIS. Only when the strike spread is the same as the fixed premium rate, is this upfront cash settlement amount equal to zero.

As an example consider a CD index swaption on a simple index which consists of only a single reference name with a notional of $100. Suppose the index has a fixed coupon rate of 3% and the CD index swaption has an expiration time of one year and a strike spread equal to the fixed coupon rate of the index. The underlying CD index swap has a maturity of 3 years after the option is exercised and its premium will be paid quarterly. Given a default-free rate of 5%, the CD index swaption has a fair value of $3.346, (calculated with the FINCAD XL function aaCDS_index_std_opt). Since the index has only one name, the CD index swap is simply a regular CDS. The corresponding CDS option has a fair value of $0.532 (calculated with the FINCAD XL function aaCDS_opt), which is much smaller than that of the CD index swaption.

For more information on FINCAD XL v9 credit derivatives coverage, please contact a FINCAD sales representative.

3. Comprehensive coverage of synthetic collateralized debt obligations (CDOs)

  • one-factor Gaussian copula models
  • quasi-analytic computating approach
  • base correlation
  • value multiple tranches simultaneously

If you are interested in learning more about using FINCAD to value Synthetic CDOs, please contact a FINCAD sales representative.

Enhancements to existing credit derivative functions in Version 8.1:

  • Extended capability and flexibility. In Version 8 credit default swap (CDS) related functions take default probability curves as inputs. If default data are CDS spreads, a user has to call a FINCAD utility function to calculate default probability curves first and then call the major valuation function. Now the enhanced versions in Version 9 can take both default probability curves and CDS spread curves. At the same time reference data tables have been made flexible to cover regular bond data tables and simple notional and recovery rate tables. Moreover, for basket CDS functions, the new versions in Version 9 includes an input correlation matrix that can be represented by a single element array when all the reference assets have an identical correlation.
  • Added sensitivity calculation. The added outputs to the CDS related functions include
    • DVOX: credit spread sensitivity, allowing a user to specify the bump size for credit spread sensitivity calculation
    • Rho of recovery rates
    • Rho of correlation or correlation matrix
    • Theta
  • Reduced variance of sensitivities. For basket CDSs where Monte Carlo simulation is used in their valuation, a better method is implemented in the calculation of sensitivities so that variances of the simulated sensitivities are reduced.

Disclaimer

Your use of the information in this article is at your own risk. The information in this article is provided on an "as is" basis and without any representation, obligation, or warranty from FINCAD of any kind, whether express or implied. We hope that such information will assist you, but it should not be used or relied upon as a substitute for your own independent research.

For more information or a customized demonstration of the software, contact a FINCAD Representative.