Credit Index. A reference index that is a function of credit events that change the value of an underlying portfolio
Issues and Challenges
Review session notes: Q: How does this differ from a basket of debt securities? A: Basket is defined as part of the contract. Whereas, with the Index, you don't reference the components. The index is based on a basket of risks (not a basket of debt instruments as such). So this is an indirection not a circularity as it is not an index of CDS contracts but of credit events as these effect a notional portfolio. In could be some form of valuation of underlying CDS (real or imagined). However this "is" the Reference Entity in the sense that it is what you refer to in order to determine the status of the portfolio, Contrast two types of CDS: Single Name and non singlename. With single name CDS: it's a binary process; if there's a default it's all over, as the contingent transaction kicks in. With indices if the index changes there would be partial payouts but the contract continues in existence,. It would pay out a portion of its value. The index indicates that some proportion has defaulted. Would deal with multi names. ALSO Index is not always a static portfolio, there may be proivisions for replacing defaulted securities. Need further research on the details. However, we only need to know them as something with a number and a publisher in order to model the CDS terms. See also: Credit Basket. This is locally defined and does form part of the CDS contract terms, but will have similar details to the index. SME Feedback - details of this term from OTPP: Because the indexes are maturity specific, it makes sense to have an entity AND an instrument with the corresponding maturity (or close to it) to measure the credit-risk of default. Premiums are standard and set depending on the composite spread at the initiation of the index, with upfront-fees to get into a deal thereafter depending on changes in the MTM of the spread. The payout per constituent credit-event is ~ Notional x weight. (cont'd - examples from OTPP): Credit-events and Payouts - Similar to single-name, and triggered by a constituent. The constituent is removed, the Notional*weight is paid, the remaining notional lowered, and the weighting re-balanced. Can be physical or cash settled. Looks like cash settled is becoming more popular. Notionals can be large but the payouts are small because of the small weights. Eg. $250MM Notional, 125 entities, weight is 1/125 for a defaulting entity = $2MM (simplified) transfer.
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