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Creating a Prototype to Automate the Valuation of a Portfolio of Single Name CDS Contracts - a FINCAD® Professional Services Consulting Engagement

The Challenge

FINCAD Professional Services faced the challenge of assisting a FINCAD client change the current process of valuing a portfolio of CDS contracts. The client was using an in-house model to mark-to-market their CDS trades and wanted to move to an automated valuation system using FINCAD Developer. They wanted a fully working prototype in FINCAD XL before implementing the solution via FINCAD Developer.

The client engaged FINCAD Professional Services to help solve their problem. The session focused on the following consulting and training services:

  1. Develop a FINCAD XL prototype for the valuation of a portfolio of single name CDS contracts.
  2. Check the FINCAD prototype against the in-house model and Bloomberg Finance LP*.
  3. Review and make recommendations to the client about improving the efficiency of curve building.
  4. Analyze sensitivity of the entire portfolio to changes in the parameters used by the FINCAD functions, as well as changes in the CDS spreads.
  5. Provide training to the client's team on pricing index CDS (CDX) and tranche contracts with FINCAD.

The Solution

During the two week session, the FINCAD Professional Services consultant worked with and trained four of the client's employees to achieve all the stated goals. The details of how each task was handled are given below.

1) Develop a FINCAD XL prototype for the valuation of a portfolio of single name CDS contracts

In order to develop a prototype for pricing single name CDS contracts, the first step was to identify the FINCAD function or functions necessary to accomplish this. In this case, just one function, aaCDS, was sufficient for pricing the CDS securities. To assist the client's team in understanding this function, they were first trained on the theory behind pricing single name CDS. Then specific details of how FINCAD prices single name CDS were discussed. Finally, a thorough overview of the input parameters used in the function was given.

At this stage it was necessary to integrate the FINCAD function with the client's internal system for managing trade specific information. The final result was the creation of two custom workbooks: A primary workbook that carries out all required data manipulation and calls aaCDS for all CDS trades in the portfolio and, a second workbook for displaying the cashflows for every CDS trade in a user-friendly fashion.

2) Check the FINCAD prototype against the in-house model and Bloomberg Finance LP

Once the FINCAD XL prototype was created, it was tested against the client's in-house model and Bloomberg Finance LP. Several trades were priced on a one-off basis as well as the aggregate price of all CDS trades. All tests showed agreement between the different valuation methods.

3) Review and make recommendations to the client about improving the efficiency of curve building

To help improve the efficiency of curve building, the FINCAD consultant wrote a suite of VB functions used for raw data cleanup and preparation, and participated in discussions regarding the benefit of purchasing RED codes.

4) Analyze sensitivity of the entire portfolio to changes in the parameters used by the FINCAD functions, as well as changes in the CDS spreads

An additional objective of the project was to analyze the sensitivity of the CDS portfolio to changes in the parameters used by the FINCAD functions, as well as changes in the CDS spreads. This objective was achieved by creating several custom template workbooks to carry out a wide variety of scenario tests as well as generating a report of the resulting analysis.

5) Provide training to the client's team on pricing index CDS (CDX) and tranche contracts with FINCAD

Not only was the team trained on the theory behind pricing single name CDS and the inputs into the FINCAD aaCDS function, they were also trained on pricing index CDS indices (CDX) and tranche contracts.

The consultant gave a detailed overview of pricing CDX contracts and tranches on CDX with FINCAD using the functions aaCDS_index_std and aaCDO_ST_DS_std_p

To download the latest trial version of FINCAD Analytics, contact a FINCAD Representative.

Single Name CDS

A single name credit default swap (CDS) is a contract which transfers credit risk from one party to another.

It can be thought of as a type of insurance contract, in which one party pays for protection against a credit event experienced by a reference entity. Purchasing a CDS corresponds to buying protection and selling a CDS corresponds to selling protection.

The protection buyer makes periodic premium payments to the protection seller on the condition that the reference entity has not suffered a credit event. If a credit event has occurred, the protection seller makes a payment to the protection buyer to compensate for the losses suffered by the reference entity.

A credit event usually corresponds to default of the reference entity, however, could also be a downgrade in the rating of the entity.

The payment upon default required by the protection seller is usually based on a recovery rate for the reference entity, or a fixed payment. If the recovery rate is equal to R, then the amount paid upon a credit event has a nominal value of (1-R), i.e. the total amount lost as a result of the credit event.

A single name CDS can be valued by calculating the values of the premium and payoff legs of the swap. The premium leg value is given by:

where q(t) is the default density of the reference entity, D(t) is the discount factor, Q(t) is the cumulative probability of default, N is the notional, C is the premium coupon, and I(t) is the accrued interest.

The payoff leg value is given by:


where R is the recovery rate.

The fair value of CDS is the difference between the premium and payoff legs:

For more information see the FINCAD math document Credit Default Swaps.

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.

 

* Bloomberg is a trademark of Bloomberg Finance LP. FINCAD is not associated in any way with Bloomberg Finance LP.