Key Differences between Bond and CDS

[harifrm1980]

Hi David

I have a question regarfding Kew Differences between Bond and CDS. Accrued Interest and Liquidity.

According to the slide, Credit protection seller receives the accrued interest intil the default date on the reference asset.

a. From whom does the seller gets the interest? from the buyer?
b. How does this happen for physically settled? As the default asset is delivered by the buyer to the seller, how is the accrued interest calculated? is it based on the Par value? if so, is the interest calcuated for the future default date on the current day?

Sorry, if these questions sound naive but i wasnt clear about few points in the slide.

Regards
Hari

 

[David Harper CFA FRM]

Hi Hari,

Good question...

a. The credit protection buyer makes regular (annual in Hull's model but quarterly is more typical) *payments* to the CDS seller. So, in the case of a credit event "in between" regular payments from the buyer to the seller, the accrued interest (coupon) is owed from the buyer to the CDS seller; if I buy CDS from you with cost of $100/year, $25 payable quarterly (so this is like my insurance premium i am paying you), and default occurs mid-way through quarter, I the buyer owe you the seller the $12.5 accrued.

b. It's the same for physical or cash settle b/c the accrual is part of the payment leg and not the settlement and the CDS buyer owes it either way. The coupon = CDS spread * par/face. Typical day count is actual/360. There is a process (e.g, give notice) but some date will be the settlement date (like with a bond) upon which AI can be calculated.

One reason it helps to be mindful of the protection buyer's accrual is: in Hull's CDS valuation
http://www.bionicturtle.com/premium/spreadsheet/6.e.3_cds_valuation/
...it always gives confusion as to why the payments (CDS payer) leg has two PVs that are added together. And it's because the CDS valuation model needs to include this accrual feature

David

 

[harifrm1980]

Thanks David for the clear explanation. It helps a lot