Pricing a credit-linked note on a CDX tranche

D. L. Chertok

November 8, 2012
Summary
A credit-linked note ( CLN ) on a tranche of the CDX index ( partially ) protects the
holder against default losses in that tranche. The holder receives a specied redemption
amount at note maturity. The note is priced using market spread quotes for a matching
CDS on this tranche.
1 Instrument description
In the event of default losses exceeding the attachment point of the tranche, the note
under consideration pays the holder the difference between the nominal and recov-
ered amounts on the protected notional. The protected notional is then reduced by
the amount of the defaulted note, and subsequent default and premium payments are
adjusted accordingly.
From the trading standpoint, the note is equivalent to the combination of a credit
default swap on the corresponding CDX and a ( defaultable ) zero-coupon bond. We
will consider both pieces separately.
1.1 Credit default swap
A credit default swap ( CDS ) is an over-the-counter ( OTC ) contract between two
counterparties in which the protection seller guarantees a one-time payment to the
buyer should a credit event occur concerning the underlying entity or entities in ex-
change for periodic premium payments from the buyer
1
. A CDS is an insurance
policy against an adverse changes in the credit quality of the underlying obligor ( sinle
name CDS ) or a basket of obligors ( collateral debt obligation, or CDO; CDO tranche;
rst-to-default basket or CDS index ). A credit event may include corporate restruc-
turing, technical default or outright bankruptcy and is specied in the CDS contract.
Should such an event occur, the seller pays the buyer the difference between the no-
tional amount of the swap and the recovered value of the defaulted obligation of the

D. L. Chertok, Ph. D., CFA, (daniel chertok@hotmail.com) is a quantitative investment professional in

Chicago, IL.
1
A combination of an upfront payment and a periodic coupon is also possible.
1
same notional amount
2
. The buyer compensates the seller for the assumed credit
risk by agreeing to make periodic coupon payments for the duration of CDS. From the
credit perspective, the buyer is long the CDS but short the risk; the reverse is true of
the seller.
1.2 Valuation algorithm
We employ a market-standard reduced-form model described in [3] which, in turn, is
based on more generic approaches described in [1] and [2]. Let us decompose a CDS
into the fee side comprising of buyers premia and the contingent side which includes
a payment from the seller to the buyer in the event of default and no payments ahould
the default not occur during the tenor of the CDS
3
. For simplicity, we consider a CDS
with a notional of $1. Since we do not know the timing of the possible credit event, the
present value of each side can only be computed in the probabilistic sense:
PV
fee
(t) =
N

i=1
c
i
d(t, t
i
)p
s
(t; t
0
, t
i
)t
i
, (1.1)
PV
cont
(t) =
N

i=1
(1 R)d(t, t
i
)p
d
(t; t
i1
, t
i
) A , (1.2)
(1.3)
where:
N - number of premium payments on the fee side;
c
i
- i th premium payment;
t
i
- time of the i-th premium payment;
d(t, t
i
) - discount factor between t and t
i
;
p
d
(t; t
i
, t
j
)- probability of a credit event inside the time interval [t
i
, t
j
]
for the underlying entity as seen at time t conditional
on no credit event inside [t, t
i
], 0 t t
i
, i = 1, N ;
p
s
(t; t
i
, t
j
)- probability of no credit event inside the time interval [t
i
, t
j
]
for the underlying entity as seen at time t conditional
on no credit event inside [t, t
i
], 0 t t
i
, i = 1, N ;
t
i
- |t
i
t
i1
|;
A - interest accrued but not paid to the seller at the time of default;
R(t) - recovery rate at time t.
2
This constitutes cash settlement; in the case of physical settlement, the owner of protection delivers
the underlying obligation to the CDS seller and receives the full notional amount in exchange. Physical
settlement is known to lead to a liquidity sqeeze when the demand for the defaulted bond articially drives
up the price because of limited suply.
3
Here we disregard the possibility of default by CDS issuer.
2
For simplicity, assume that R(t) = R and is known a priori. This reduces ( 1.1 ) -
( 1.2 ) to
PV
fee
=
N

i=1
c
i
d(t, t
i
)p
s
(t; t
0
, t
i
)t
i
, (1.4)
PV
cont
= (1 R)
N

i=1
d(t, t
i
)p
d
(t; t
i1
, t
i
) A . (1.5)
(1.6)
A credit event may occur at t

[t
i1
, t
i
] with probability
p
d
(t; t
i1
, t
i
) = p
s
(t; t
0
, t
i1
) p
s
(t; t
0
, t
i
)
= [1 p
d
(t; t
0
, t
i1
)] [1 p
d
(t; t
0
, t
i
)]
= p
d
(t; t
0
, t
i
) p
d
(t; t
0
, t
i1
), 0 t t
i
, i = 1, N . (1.7)
The expected average accrual can be approximated by
A
N

i=1
c
i
d(t, t
i
)[p
d
(t; t
0
, t
i
) p
d
(t; t
0
, t
i1
)]
t
i
2
, (1.8)
(1.9)
which implies that the credit event occurs at the midpoint of [t
i1
; t
i
], i = 1, N and
interpolates linearly over default probabilities.
Now we can compute market-implied default probabilities
4
from available market
spread quotes with the help of ( 1.1 ) - ( 1.8 ). Suppose that c
i
, i = 1, N, in ( 1.1 )
correspond to the quoted par spread at time t = 0 so that
PV
total
= PV
fee
+ PV
cont
= 0
5
. (1.10)
Setting t = t
0
= 0, we obtain

i=1
c
i
d
i
[1 p
i
]t
i
+ (1 R)
N

i=1
d
i
[p
i
p
i1
]

i=1
d
i
c
i
[p
i
p
i1
]
t
i
2
= 0 . (1.11)
Solving for p
N
, we get
p
N
=
1
d
N

1 r +
c
N
t
N
2

c
N
d
N
t
N

1
p
N1
2

+
N1

i=1
c
i
d
i
t
i

1
p
i
+ p
i1
2

+ (1 R)

d
N
p
N1

N1

i=1
d
i
(p
i
p
i1
)

, (1.12)
4
More precisely, we can compute upper boundaries of the default probabilities in question. The resulting
values also include the liquidity premium, supply and demand variations, average counterparty risk etc. [4].
3
This is a recursive algorithm for calculating p
i
, i = 1, N, with the starting points
p
0
= 0 , (1.13)
p
1
=
c
1
t
1
1 R +
c1t1
2
, (1.14)
since t
1
= t
1
.
Having computed p
i
, i = 1, N, from ( 1.12 ) - ( 1.14 ), we can substitute the actual
deal spread for c
i
, i = 1, N, to get the CDS mark-to-market from ( 1.10 ).
Interest rate and cpread sensitivities of a CDS can be computed by translating the
interest rate and spread
6
curves by x b.p. up and down and computing
PV 01
IR
=
PV
curve x b.p. down
PV
curve x b.p. up
2x
, (1.15)
PV 01
spread
=
PV
spread y b.p. down
PV
spread y b.p. up
2y
, (1.16)
1.3 Zero-coupon bond
The price of a risk-free zero-coupon bond of unit ( $1 ) notional is simply the value
of the discount factor d
riskfree
(T) corresponding to its maturity T. If we wish to
account for a market-implied default probability, we can use a corporate yield curve of
the same quality in place of a risk-free curve. The simples way to do it is to translate
( shock ) the risk-free curve up:
r
corporate
(t; t
start
, t
end
) r
riskfree
(t; t
start
, t
end
)
+ (r
corporate
(t; t, T) r
riskfree
(t; t, T)) ,(1.17)
This shortcut does not account for the term structure of the corporate yield curve or
default correlation between the underlying entity and the CLN issuer, but is otherwise
accurate as a rst-order approximation. Using the curve determined by ( 1.17 ), the
price of a defaultable corporate bond equals
PV
corp. bond
= d
riskfree
(T) . (1.18)
where d
riskfree
(T) is the discount corresponding to T on the curve.
2 Example
We consider a $10MM notional CLN maturing on 6/20/2017 with embedded protec-
tion of $8.5MM on Tranche C ( 15% 25% of losses ) of the CDX8.HY index. The
note was issued a AA obligor, pays no interest and returns the full principal at matu-
rity. The protection terminates at the same time as the tranche, i.e., on 6/20/2014. We
compute the value of protection based on standard CDS terms and 40% recovery rate.
The note was valued on 5/8/2007 using the par swap curve in effect on that day, market
CDS spread on Tranche C of 580 b.p. and AA spread of 42.27 b.p. to the risk-free
curve. The results of the calculation are presented in Figure 1.
6
Or spread value, if valuation is performed using a at spread curve c
i
= S i = 1, N.
4
References
[1] Hull J. and White, A. Valuing credit default swaps I: No counterparty
default risk, 2000. http://papers.ssrn.com/sol3/papers.cfm?
abstract_id=1295226.
[2] Hull J. and White, A. Valuing credit default swaps II: Modeling default corre-
lations, 2000. papers.ssrn.com/sol3/papers.cfm?abstract_id=
1295225.
[3] J.P. Morgan Securities, Inc. Par credit default swap spread approximation from
default probabilities. Technical report, , 2001.
[4] Neis, E., Longstaff, F and Mithal, S. Corporate yield spreads: De-
fault risk or liquidity? New evidence from the credit default swap market,
2004. http://citeseerx.ist.psu.edu/viewdoc/download?doi=
10.1.1.199.2105&rep=rep1&type=pdf.
5
Fig. 1: CLN price calculation example
6