Impact of subprime crisis on credit default swap

Abstract

This report looks at the evolution of the CDS over the credit crisis. The CDS has gone through some significant changes after the crisis and some of them have gone towards making the pricing more standard and trading more robust. This would help in increasing the life of the product in the market. The changes which have been made help in protecting the investors more and bringing transparency into the system. We begin by analyzing the models which have been used for CDS pricing including the Bloomberg, Upfront pricing model and the standardized JP model. The shortfalls for each of different models are analyzed and we also discussed how JP model brought about standardization and transparency in trading and pricing. These changes also improved the pricing as per the ISDA standards. Then we moved to look at the one of the major changes which were brought about by the crisis which was in the Bond CDS basis. The basis is defined as the differing in the pricing between the bond and the corresponding CDS. Traditionally the basis had been trading positive and there had been lots of positive and negative basis trades that have been put on and thought to be risk free. But the crisis taught us that the hugely invested basis trades are not totally risk free. In early 2009 Boaz Weinstein, a trader and co-head of credit trading at Deutsche Bank is down $1bn, Ken Griffin of Citadel is down 50% and John Thain of Merril is said to be down by more than $10bn. The big part of these losses is due to a negative basis trade. This shows that the basis trade is not risk-free. So we started analyzing the basis deeper by doing a secondary literature survey to come up with parameters which affect and basis, and the nature of the impact. We looked into the risk involved in the basis trades and how a JTD analysis would becoming important when such extreme events like the current credit crisis takes place, We used the same parameters and found proxy for them in order to model and empirically explain the basis, so that the changes in market condition we should be able to predict the direction and quantum of basis, so that we can take suitable positions. And get out of the basis trades in time. We used a four parameter model, and we proved empirically in the end that it’s just the major four parameters, viz, funding cost, risk premium, liquidity situation and counter party risk explains the basis and also its direction with a huge level of confidence.