Structured Products and Related Credit Derivatives: A Comprehensive Guide for Investors

CHAPTER 8

Valuation of Subprime ABS Credit Default Swaps

Shane Whitworth, CFA

Associate Analyst

Wachovia Capital Markets, LLC.

Credit derivatives in recent years have dramatically increased the size and liquidity of the debt markets. Credit default swap (CDS) contracts are now available on a wide variety of financial products, including subprime ABS. The subprime ABS market includes structured bonds that are backed by first- and second-lien subprime mortgages. The central focus of this chapter is to provide a solid understanding of CDS valuation techniques as they pertain to the subprime ABS market. The CDS contracts discussed in this chapter are single-name CDS, which means that we are discussing a credit default swap on a single bond rather than a portfolio of bonds. In Chapter 11, credit default swaps as they are used to created synthetic collateralized debt obligations are discussed.

CREDIT DEFAULT SWAPS

Credit default swap contracts are designed to allow one to trade in just the credit risk of a financial product. If, for instance, you owned a bond and you wanted to hedge out all of the credit risk related to that bond, you could do so with a CDS contract. The process of buying the hedge is called buying protection, as you would be buying protection against a credit event on the bond. Likewise, the counterparty that is insuring you against losses on the bond is selling protection to you. When a party sells protection, it is going long the credit risk. The buyer of protection ...