Hey Guys! I am bit confused about the upfront premium part in credit default swaps in Derivatives. I do understand that coupons are standardized 1% for Investment Grade and 5% for Non-Investment.
Formula is - (Credit Spread - Fixed Coupons ) * Duration
Can anyone explain me meaning and interpretation of the formula. I really get confused on how much we pay as unfront. If possible can you explain with an example.
How we intrepret what long and short pay. Short being the buyer of the CDS who will get paid if the issuer defaults.
The formula your are referencing is actually a “short cut” formula to figuring out who is paying who up front. To expand on the idea of standardized coupons - basically if you are buying CDS protection you are paying a 1% coupon (assuming IG) for the entire term to the protection seller regardless of the actual credit rating of the underlying name. These seems unfiar that someone selling CDS protection would get the same 1% coupon for protection on a XOM (Exxon Mobil) bond (Aaa issuer) or on a bond from Time Warner (Baa2 issuer) - yet they are both considered IG. Therefore there is a spread to this 1% coupon.
For XOM the CDS spread may be 50 bps - meaning the actual cost of credit protection should be 50bps and not the 1% coupon payment. Therefore the issuer would owe the protection buyer 50 bps x the length of the swap (for ease of this example say it is just 1 year). Therefore at initiation the protection seller would pay the buyer the PV of the 50 bps and in return the buyer of the CDS would pay the 1% coupon. Therefore the net cost is the 50 bps.
For the TWC bond lets say the spread is 300 bps. Therefore the seller of the protection would want more than the 1% coupon to take the credit risk off the hand of the buyer. Therefore the buyer of the CDS would need to pay the seller an additional 200 bps up front in order to compensate the seller of the protection. In addition, the buyer will also pay the 1% standardized coupon. The net cost is the 300 bps spread. Again this is the short cut way of figuring this out.
It’s a long explaination but I hope that makes sense.