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The Journal of Derivatives

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Article

Force-Fitting CDS Spreads to CDS Index Swaps

Dominic O’Kane
The Journal of Derivatives Spring 2011, 18 (3) 61-74; DOI: https://doi.org/10.3905/jod.2011.18.3.061
Dominic O’Kane
is an affiliated professor of finance at the EDHEC Business School in Nice, France.
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  • For correspondence: dominic.okane@edhec-risk.com
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Abstract

CDOs present some of the thorniest valuation problems in derivatives these days. The most widely used approaches are based on the strong assumption that the individual securities in the underlying pool are homogeneous. The most popular portfolios used as underliers are constructed from credit default swaps to replicate standard credit indexes, like CDX.NA.IG, or iTraxx, each of which contains CDS on 125 names. The CDO model assumes they can be treated as if they were identical, but in reality, their spreads in the market can be quite diverse. The result can be an internal discrepancy between the pricing of the CDO tranches and the 125 CDS they are composed of, especially with regard to the term structure of credit spreads. Although O’Kane shows that transactions costs are too large for the apparent arbitrage trades to be profitably implemented, it is still undesirable for model values for closely related instruments to be inconsistent with one another. In this article, O’Kane first gives a detailed description of the pricing conventions in the two markets and explains how differences in the way features like restructuring clauses are treated give rise to different valuations. He then offers a way to harmonize the two by appropriately modifying CDS quotes.

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The Journal of Derivatives: 18 (3)
The Journal of Derivatives
Vol. 18, Issue 3
Spring 2011
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Force-Fitting CDS Spreads to CDS Index Swaps
Dominic O’Kane
The Journal of Derivatives Feb 2011, 18 (3) 61-74; DOI: 10.3905/jod.2011.18.3.061

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Force-Fitting CDS Spreads to CDS Index Swaps
Dominic O’Kane
The Journal of Derivatives Feb 2011, 18 (3) 61-74; DOI: 10.3905/jod.2011.18.3.061
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  • Article
    • Abstract
    • THE CDS INDEX
    • MECHANICS OF SINGLE-NAME CDS
    • MECHANICS OF A CDS INDEX
    • SPREAD QUOTATION CONVENTIONS AND NOTATION
    • THE MARKET-QUOTED VALUE OF A CDS INDEX
    • THE INTRINSIC VALUE OF A CDS INDEX
    • THE CDS INDEX BASIS
    • THE PORTFOLIO SWAP ADJUSTMENT
    • MATHEMATICS OF THE ADJUSTMENT
    • FITTING ALGORITHMS
    • NUMERICAL TEST
    • RESULTS
    • CONCLUSIONS
    • APPENDIX
    • ENDNOTES
    • REFERENCES
  • Info & Metrics
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  • PDF (Subscribers Only)

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