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7 August 2003
When bonds are distressed, protection is often quoted as an up-front payment rather than a “running”
spread paid until the earlier of default or maturity. This article examines the pricing, risk profile and
performance of up-front credit default swaps and compares them to the standard running trades.
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
2. UP-FRONT PROTECTION
1
Reprinted from Quantitative Credit Research Quarterly, Volume 2003-Q3.
August 2003 Please see important analyst(s) certifications at the end of this report. 1
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
Equally, an investor can use the up-front contract to sell protection in return for a single
initial payment. The investor is then assuming the credit risk of the reference credit until
the maturity date of the contract.
If default occurs before maturity, the protection buyer typically delivers assets with a face
value equal to that of the protection, to the protection seller in return for the face value
amount in cash. Alternatively, the protection may be settled in cash format, exactly as in a
standard running CDS. The value of protection delivered is equivalent to par minus
recovery, where recovery is the price of the cheapest-to-deliver (CTD) asset in the basket
of deliverables2.
More details on the exact definitions of credit events and the mechanics of delivering
protection can be found in O’Kane (2001). Figure 1 shows a schematic representation of
the cashflows in running and up-front CDS contracts.
Protection Seller
Up-front Payment
Running Spread
Time
Running
Up-front
Protection Buyer
2
See “Valuation of Restructuring Credit Event in Credit Default Swaps”, O’Kane, Pedersen and Turnbull, Lehman
Brothers Quantitative Credit Research Quarterly, May 2003.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
1. They eliminate any uncertainty about the size and timing of the payment for
protection.
2. The distribution of outcomes from an up-front contract is typically narrower for an
up-front CDS than for a running CDS. This is especially true when spreads are wide.
For this reason, risk aversion makes protection sellers and buyers prefer up-front to
running. This will be explained in detail later.
3. Dealers may feel more uncomfortable quoting spreads in excess of 1000bp, which is
what would be required for many distressed credits. This is also the regime in which
bonds begin to trade on a price basis. It is no surprise that the same should happen to
CDS.
4. Very wide spreads may also pose problems for analytics unless carefully
implemented. For example, the payment of the accrued premium following a credit
event has a significant effect and must be implemented correctly.
An investor’s preference for up-front or running trades, therefore, also depends on the
valuation and price sensitivity of up-front trades. Before discussing these, we describe
some examples to fix ideas and motivate the remainder of the article. These examples
illustrate the mechanics of up-front protection and also highlight the market views and
risks implicit in such trades.
3. UP-FRONT TRADES
As with running CDS, up-front CDS can be used to implement basis trades between the
cash and CDS market. They can also be used to express views on the likely timing of
default and expected spread movements. To discuss these, it is best to use an example and
for this we will use a 5-year maturity, 6% coupon bond which pays annually.
Suppose initially this bond was distressed, trading at a clean price of $75 with an up-front
premium quoted at $33 on a face value of $100. As we will show in the next section, the
model-implied CDS spread corresponding to this up-front price, assuming a 40%
recovery rate, is 1050bp.
The generic basis trade will consist of an investor being long the bond and long
protection on the same face value via either a running or up-front CDS. For simplicity,
we will assume that the bond and running CDS cashflow dates are synchronized. We also
assume that the funding rate and reinvestment rates are Libor flat at a constant 3%.
We now examine the differences between running and up-front trades in terms of
cashflows, carry and MTM for a range of scenarios.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
Reinvested carry
Time (Y) Bond ($) Upfront CDS ($) Funding ($) NET ($)
($)
0 -75.00 -33.00 108.00 0.00 0.00
1 6.00 0.00 -3.24 2.76 2.76
2 6.00 0.00 -3.24 2.76 5.60
3 6.00 0.00 -3.24 2.76 8.53
4 6.00 0.00 -3.24 2.76 11.55
5 106.00 0.00 -111.24 -5.24 6.65
As Table 1 shows, buying up-front protection results in a positive carry trade. In each
period, the net carry is $2.76 per $100 face, which is the difference between the 6%
coupon earned on the bond, and the 3% funding paid on a total initial borrowing of $108
($75 for the bond + $33 up-front protection). The last payment is negative, as the investor
has to pay back the funding principal, but the total reinvested carry over the life of the
trade is still positive.
Contrast this with Table 2 below, which shows the cashflows when protection is bought
on a running basis. This is a negative carry trade, since the total payments in each period,
consisting of $10.50 running protection and $2.25 bond funding, exceed the $6 coupon
income from the bond. Even though the last cashflow is positive to the investor, the net
reinvested carry is still negative.
Reinvested carry
Time (Y) Bond ($) Running CDS ($) Funding ($) NET ($)
($)
0 -75.00 0.00 75.00 0.00 0.00
1 6.00 -10.50 -2.25 -6.75 -6.75
2 6.00 -10.50 -2.25 -6.75 -13.70
3 6.00 -10.50 -2.25 -6.75 -20.86
4 6.00 -10.50 -2.25 -6.75 -28.24
5 106.00 -10.50 -77.25 18.25 -10.84
In this scenario, a protection buyer who expects the reference credit to survive but wishes
to hedge his downside “just in case”, would prefer to pay for protection in up-front form
rather than a running spread, in order to avoid locking in a high contractual spread for the
life of the trade.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
Reinvested carry
Time (Y) Bond ($) Upfront CDS ($) Funding ($) NET ($)
($)
0 -75.00 -33.00 108.00 0.00 0.00
1 6.00 0.00 -3.24 2.76 2.76
DEFAULT 35.00 65.00 -108.00 -8.00 -5.24
Following the credit event, the protection buyer receives $35 from the sale of the
distressed bond and $65 from the up-front CDS, but has to repay the funding principal of
$108, resulting in a net negative cashflow of $8. The reinvested carry from the trade is
therefore a negative -$5.24.
Compare this to a protection buyer who chooses to trade on a running basis. This is
illustrated in Table 4 below in the same scenario as above.
The protection payout following the credit event is the same as in the up-front case, but
the funding principal to be repaid is $75, which nets a positive cashflow of +$25 to the
protection buyer. The net reinvested carry from the trade is therefore $18.25.
The protection buyer does better in the running CDS format. As a result, protection
buyers who have a view that default is almost certain should prefer to trade on a running
CDS format. Protection sellers who view default as imminent should prefer to trade on an
up-front basis.
We see that the gain in the value of the bond has been almost exactly offset by the fall in
the value of the up-front CDS and the funding.
Compare this with the case of running protection. The presence of a risky premium leg
makes the unwind value of a running CDS more sensitive to spread movements than an
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
up-front CDS. For this reason, the adverse impact of spread tightening is more
pronounced as shown below in Table 6.
Here we see that the loss due to the spread tightening is greater than the increase in the
bond price. It shows that a protection buyer would have been better off buying up-front
protection on the trade date since this exhibits lower spread sensitivity than a running CDS.
In each case shown the investor has hedged the bond’s face value and so has full principal
protection. However, the longer the issuer survives, the better the performance of an
upfront trade relative to running for a protection buyer, and vice-versa for a protection
seller. If protection is triggered in one year, the running trade has a higher P&L than the
up-front trade. As the timing of the credit event recedes, the performance of the up-front
trade improves relative to running, as the running spread paid eventually exceeds the
initial cost of up-front protection. Beyond a point, the P&L of the up-front trade exceeds
that of the running trade.
We now turn to the formal valuation and marking to market of up-front protection trades
and discuss their sensitivity to various market factors.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
T
U (t , T ) = E Q (1 − R ) ∫ Z (t , s )Q (t , s )λ ( s ) ds (1)
t
where
λ(s) is the hazard rate, the instantaneous probability of default in the period [s,s+ds]
conditional on surviving to time s. This is usually assumed to be deterministic and
independent of interest rates. See O’Kane and Turnbull (2003) for a discussion.
Q(t,s) is the arbitrage-free survival probability of the reference entity from valuation
time t to time s.
Z(t,s) is the Libor discount factor from valuation date t to time s.
The next step is to calibrate this model in order to value the up-front protection. There are
essentially three ways to do this, which we describe next.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
4.3. Example
Assuming a recovery rate of 40%, a flat 3% risk-free rate, a flat3 hazard rate, a 5-year
bond trading with a 5% annual coupon and a price of $85 implies a term structure of
survival probabilities. Substituting these results into the up-front pricing formula gives us
a value for the up-front protection of $22. Observe that this is greater than par minus the
full price of the bond, i.e. $15 (= $100–15).
This is exactly what we expected from our observation in the example at the start of this
section, where we noted that an up-front value of $15 presents an arbitrage. The value of
the up-front implicitly should be greater to take into account the coupon payments on the
bond which would be paid. As a result, the investor who buys the bond and buys up-front
must pay $85+$22=$107. The $7 represents the expected present value of the coupon
payments on the bond. Just to be clear, the valuation equation (1) of the up-front does not
explicitly know about the coupons on the bond. However, it implicitly knows about the
bond since the survival probabilities have been calibrated to the bond price.
3
This is the simplest assumption we can make, but it may not be realistic as a distressed credit typically has a
downward sloping hazard rate term structure.
August 2003 8
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
21.00
20.00
19.00
Upfront Price
18.00
17.00
16.00
15.00
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
Interest Rate
80.00
R = 30%
70.00
60.00
Upfront Price
50.00
40.00 R = 50%
30.00
20.00
10.00
0.00
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
Spread
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
However, the protection amount paid on default (1-R) decreases. These effects tend to
cancel out for low spreads, though for high spreads (>1000bp) the effect can be material.
50.00
45.00
40.00 S = 1500 bp
35.00
Upfront Price
30.00
25.00
20.00
15.00
S = 500 bp
10.00
5.00
0.00
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
Recovery Rate
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
60.00
S = 1500 bp
50.00
40.00
Upfront Price
30.00
S = 500 bp
20.00
10.00
0.00
10
12
14
16
18
Years to Maturity
What we have shown so far is the sensitivity of the up-front price to a number of
important parameters. For those trading up-front CDS, we need to determine the
sensitivity of the mark-to-market to market factors. This is addressed in the next section.
This is because U(t,T) is the cost of entering into an offsetting position on the reference
credit at time t. However this ignores the cost of funding or investing the upfront
payment.
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Consider the position of an investor selling protection on an up-front basis. At time 0, the
investor receives U(0,T). Assuming that this is reinvested at Libor flat, the investor’s
wealth at time t is given by
U(0, T) ⋅ B(0, t )
where B(0,t) is the value of a dollar continuously reinvested at Libor between 0 and t. If,
at time t, the investor enters into an offsetting contract, buying up-front protection for the
remaining time from t to T at the price U(t,T), then the net gain or loss from this trade is
PLUF
S ( t , T ) = U(0, T )B(0, t ) − U( t , T )
For a long protection position, assuming that the funding of the initial payment of U(0,T)
is also done at Libor flat, we have
PLUF UF
L ( t , T ) = U( t , T ) − U (0, T ) ⋅ B(0, t ) = − M S ( t , T )
Clearly, different borrowing and lending rates can break this symmetry.
M RUN
L ( t , T) = U ( t , T) − S(0, T ) ⋅ RPV 01( t , T )
= [S( t , T) − S(0, T )] ⋅ RPV 01( t , T)
where RPV01(t,T), is the present value at time t of a 1bp premium stream which
terminates at the earlier of maturity time T or default. See the references for a discussion
of the MTM of running default swaps.
The difference is clear. In both cases the protection buyer is long the protection which is
worth U(t,T). This will change in value as spreads, interest rates and recovery rate
assumptions change.
The difference is in the premium leg. In an up-front contract, all the market information
from the trade date to maturity is incorporated into a single initial payment U(0,T). This
has no sensitivity to any subsequent market inputs and no exposure to future interest
rates, credit spreads or recovery rates.
In contrast, the spread leg of the standard CDS is sensitive to all of these market variables
since it is the discounted expectation of risky spread payments. In other words, in an
upfront trade the investor has already paid (or received payment) for the remaining
protection, worth U(t,T), whereas in a running trade part of the payment, which is
contractually fixed at time 0, this payment is made between t and min[T,τ] where τ is the
time of the credit event.
For an investor using up-front CDS to buy or sell credit risk, it is essential to understand
how sensitive the valuation of the position is to changes in market variables. We now
examine the sensitivity of running and upfront trades to spreads and interest rates.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
M RUN
L ( t , T) = [S( t , T) − S(0, T)] ⋅ RPV 01( t , T )
As low market spreads, the value of the MTM is negative. As the value of S(t,T)
increases, the risky PV01 decreases. As the spread increases beyond S(t,T)=S(0,T), the
MTM becomes positive. This is shown in Figure 8.
Figure 8. Relative Spread Sensitivity of the MTM of Up-front and Running CDS.
80.00
Running
60.00
MTM (Long Protection)
40.00
20.00 Upfront
0.00
-20.00
-40.00
-60.00
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
Spread
We see the same sort of behavior for the up-front protection. However, the slope of the
running CDS curve is different to that of the up-front CDS because the running CDS has
a risky PV01 effect – at low spreads the risky PV01 is high, while for high spreads the
risky PV01 is low. This makes the running protection more negative at lower spreads and
more positive at high spreads. At very high spreads the upfront CDS value tends
asymptotically to (1-R)-U(0,T) while that of the running CDS tends to (1-R) since the
value of the premium leg tends to zero.
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Figure 9. Interest Rate Sensitivity of MTM for Running and Up-front Trades
0.02
0.01
0.00
-0.01
-0.01
Upfront
-0.02
1000
2000
3000
4000
5000
6000
7000
8000
9000
10000
Spread
At low spreads the MTM of the running CDS is negative so that an increase in interest
rates increases the value of the contract and the IR01 is positive. The interest rate
sensitivity of the MTM of the up-front CDS is only to the contingent incoming payment
of (100%-R) and so is negative. However, at very high spreads the sensitivity to interest
rates of both contract types tends to zero as they both tend to contracts paying a certain 1-
R immediately.
7. CONCLUSIONS
Up-front CDS trades are common for short-dated and distressed bonds. For protection
sellers, they are attractive as a means to lock in the PV of protection as a sure payment
rather than a risky cashflow stream. For protection buyers, they offer the opportunity for
better carry trades and a way to avoid being locked into paying high spreads. If the issuer
survives, an up-front trade will outperform a running trade.
The relative performance of running and up-front trades depends on whether a credit
event occurs and when. Which is chosen should reflect the investor’s view. We
summarise the main conclusions below.
• Buying a bond and buying protection is not a credit-neutral trade. The net P&L
depends on the timing of the credit event, and an investor’s P&L can be significantly
different depending on whether protection is bought on an up-front or running basis.
• A protection buyer who expects the reference credit to survive, but wishes to hedge
downside risk “just in case”, should prefer to pay for protection in up-front form
rather than as a running spread. This is in order to avoid locking in a high contractual
spread for the life of the trade.
• Protection buyers who have a view that default is almost certain should prefer to trade
on a running CDS format since the spread will only be paid until the credit event. For
the same reason, protection sellers who view default as imminent should prefer to
trade on an up-front basis.
• A protection buyer who is taking a strong view on a spread movement should prefer a
running CDS as this exhibits a higher spread sensitivity than an upfront CDS. Equally
the downside can be greater.
Up-front trades can therefore be used to express a view on the timing of a credit event,
and also take exposure to a different risk profile than running trades.
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Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3
REFERENCES
Berd, Mashal and Wang (2003), Estimation of Implied Default and Survival Probabilities
from Credit Bond Prices, Lehman Brothers QCRQ, August 2003.
Jarrow and Turnbull (1995), Pricing Derivatives on Financial Securities Subject to Credit
Risk, Journal of Finance, Vol 50 (1995), 53-85.
O’Kane (2001) Credit Derivatives Explained, Lehman Brothers, March 2001.
O’Kane and Schloegl (2001), Modelling Credit: Theory and Practice, February 2001.
O’Kane and McAdie (2001), Trading the Basis, Risk Magazine, October 2001.
8. APPENDIX
Given that a bond and a credit default swap are linked to the same reference entity, cross
default provisions mean that they should default together and so have the same term
structure of survival probabilities Q. Suppose the full price at time t of a bond issued by
the same issuer as the reference credit, maturing in T years and paying an annual coupon
rate of C, is given by B(t,T). If coupons are paid semi-annually, the model-based
valuation formula for a bond is given by
C n M
B( t, T ) = ∑
2 j=1
Z( t, t j )Q( t , t j ) +Z( t, T)Q( t , T) + R ∑ Z( t, t m )(Q( t , t m −1 ) − Q( t , t m ))
m =1
The first term is the sum of the risky discounted coupons. The second term is the PV of
the principal repaid at maturity, weighted by the probability that the issuer survives to
maturity. The third term is the PV of the price of the bond after a credit event, R, which is
realised if the credit event occurs before maturity. We have assumed the issuer defaults at
M discrete times and that coupons default with no recovery.
The survival probabilities can now be calibrated to a term structure of bond prices using
some best-fit technique. See Berd, Mashal and Wang (2003) for details of a fitting
approach.
August 2003 15
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