Constant Maturity Credit Default Swap
Encyclopedia
A constant maturity credit default swap (CMCDS) is a type of credit derivative
product, similar to a standard Credit Default Swap
(CDS). Addressing CMCDS typically requires prior understanding of credit default swap
s.
In a CMCDS the protection buyer makes periodic payments to the protection seller (these payments constitute the premium leg), and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults. Differently from a standard CDS, the premium leg of a CMCDS does not pay a fixed and pre-agreed amount but a floating spread, using a traded CDS as a reference index. More precisely, given a pre-assigned time-to-maturity, at any payment instant of the premium leg the rate that is offered is indexed at a traded CDS spread on the same reference credit existing in that moment for the pre-assigned time-to-maturity (hence the name "constant maturity" CDS). The default or protection leg is mostly the same as the leg of a standard CDS. Often CMCDS are expressed in terms of participation rate. The participation rate may be defined as the ratio between the present value of the premium leg of a standard CDS with the same final maturity and the present value of the premium leg of the constant maturity CDS. CMCDS may be combined with CDS on the same entity to take only spread risk and not default
risk on an entity. Indeed, as the default leg is the same, buying a CDS and selling a CMCDS or vice versa will offset the default legs and leave only the difference in the premium legs, that are driven by spread risk.
Valuation of CMCDS has been explored by Damiano Brigo
(2004) and Anlong Li (2006)
Credit derivative
In finance, a credit derivative is a securitized derivative whose value is derived from the credit risk on an underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself...
product, similar to a standard Credit Default Swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
(CDS). Addressing CMCDS typically requires prior understanding of credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...
s.
In a CMCDS the protection buyer makes periodic payments to the protection seller (these payments constitute the premium leg), and in return receives a payoff (protection or default leg) if an underlying financial instrument defaults. Differently from a standard CDS, the premium leg of a CMCDS does not pay a fixed and pre-agreed amount but a floating spread, using a traded CDS as a reference index. More precisely, given a pre-assigned time-to-maturity, at any payment instant of the premium leg the rate that is offered is indexed at a traded CDS spread on the same reference credit existing in that moment for the pre-assigned time-to-maturity (hence the name "constant maturity" CDS). The default or protection leg is mostly the same as the leg of a standard CDS. Often CMCDS are expressed in terms of participation rate. The participation rate may be defined as the ratio between the present value of the premium leg of a standard CDS with the same final maturity and the present value of the premium leg of the constant maturity CDS. CMCDS may be combined with CDS on the same entity to take only spread risk and not default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
risk on an entity. Indeed, as the default leg is the same, buying a CDS and selling a CMCDS or vice versa will offset the default legs and leave only the difference in the premium legs, that are driven by spread risk.
Valuation of CMCDS has been explored by Damiano Brigo
Damiano Brigo
Damiano Brigo is an applied mathematician, and current Gilbart Chair of Financial Mathematics at King's College, London, known for a number of results in systems theory, probability and mathematical finance.-Main results:...
(2004) and Anlong Li (2006)