By Merrill Lynch
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Extra resources for Credit Derivatives Handbook - Volume 1
In fact, the Upfront CDS price is simply the Risky PV of the Coupon Leg of the equivalent Running CDS. Hence, while the cashflow profile changes in moving from a Running to an Upfront CDS, the economic value of the transaction to both the protection buyer and seller remains identical. . but differing dynamics impacts ultimate P&L However, while the Upfront CDS price is determined such that on a PV basis, the investor is indifferent between Running and Upfront CDS, the differing mechanics with respect to cashflow, funding and carry can alter the variance of P&L outcomes between trading Upfront and Running CDS.
Credit Event over the Life of the Trade. The investor delivers the bond in return for a 100% payment. Depending on the timing of the credit event, the investor enjoys some amount of positive carry. While we have ignored funding costs and counterparty risk issues in the analysis, an arbitrage exists if the Upfront CDS price is less than the bond’s discount to par. We conclude that the Upfront CDS price will cost more than the bond’s discount to par. Hence, if P is the price of the bond, the lower bound of the Upfront CDS price is 100%-P.
To further complicate matters there is the Z-spread valuation measure which provides a differing methodology to asset swaps. None of these measures is perfect, but it is important to understand their pluses and minuses when looking at bonds trading away from par. In such circumstances, the correct choice of valuation measure will be crucial in determining absolute (as opposed to relative) value. Asset Swap Structures Asset swaps are used to transform the cashflows of bonds An asset swap is a transaction which transforms the cashflows of a bond through the application of one or more swaps.