Charting a Course Through the CDS Big Bang
by Johan Beumee 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 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.
Keywords: Credit Default Swap, Upfront CDS, Running CDS, CDS conversion, Recovery Rate.
Related reading: ISDA CDS Standard Model