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Credit Derivatives: Trading, Investing and Risk Management, Second Edition by Geoff Chaplin

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12
Forward CDS; Back-to-Back CDS, Mark to Market and CDS Unwind

12.1 FORWARD CDS

A forward start CDS is like a vanilla CDS except that the risk does not begin until the start date - say 2 years’ time, and lasts until (say) 7 years’ time. In the event of a default in the first two years the contract terminates (and there is no capital payment). No premium is paid or begins to accrue until the forward start date.
How would you hedge a EUR 10m position using vanilla CDSs?
The obvious choice is a long 10m 7-year protection position (at 350 bp say) and a short 10m 2-year one (at 250 bp). In the event of default in the first two years, we can then - as long as our documentation is correct - deliver the bond we get delivered on the 2-year short position into the 7-year long position, the forward CDS we have written knocks out, and we have no net capital gain or loss.
However, because the 2- and 7-year CDS premiums are different, the premium cashflows leave an unhedged risk arising from these premium differences, starting at zero and rising to a maximum of 200 bp after two years. After two years the premium on the forward CDS starts (at a higher rate than the 7-year CDS: say 407 bp) while the premium on the 2-year has ceased - a positive cashflow starts to reduce the accumulated negative cashflow from the first two years of the life of the deal. See Figure 12.1.
How does the exposure appear in the books? (See ‘chapter 12.xls’ sheet ‘forward CDS’.)
Day 1: There is no value difference: ...

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