Force-fitting CDS Spreads to CDS Index Swaps

Issues of contemporaneity, liquidity, different restructuring clauses and market supply and demand, all contribute to the fact that the market quoted term structure of CDS index spreads does not al ...

Author(s):

Dominic O#39;Kane

Professor of Finance, Edhec Business School

Issues of contemporaneity, liquidity, different restructuring clauses and market supply and demand, all contribute to the fact that the market quoted term structure of CDS index spreads does not always agree with the term structure of CDS index spreads implied by the CDS term structures of the constituent credits. This can cause problems for those who wish to calibrate no-arbitrage pricing models in order to price and hedge index derivatives. This is true even if bidoffer spreads prevent the arbitrage from being tradeable. This problem is especially relevant for single tranche index derivatives where the model must calibrate to the index tranche prices but the output hedges are expressed in terms of single-name CDS. This paper presents an approach which can be used to overcome this problem which is simple, intuitive and fast.

Type: Working paper
Date: le 04/04/2011
Research Cluster : Finance

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