Force-Fitting CDS Spreads to CDS Index Swaps

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.