credit default swaps (cds) /options description a pays b a regular premium (for a cds)/one-off...

• Credit Default Swaps (CDS) /Options• Description• A pays B a regular premium (for a CDS)/one-off premium (for a option)• B pays A the credit-event payment if a credit event takes place on the reference

entity• Result• A is short the credit risk of the reference entity• B is long the credit risk of the reference entity• Details• What is the credit-event payment?• What is the reference entity?• What is a credit-event?• Setting a price for the settlement: auction• Uses• As for TRS, BUT cleaner: no exposure to interest rate risk and no capital

appreciation/depreciation adjustment• There are numerous variants on the CDS:• e.g. Constant Maturity CDS (CMCDS), Constant Spread Swap, Recovery Swap

Credit Derivative Instruments

CDS Market Growth-Reference Entities

• Credit Default Swaps - What is a credit event?– Bankruptcy – i.e. official/legal filing– Failure to pay – usually subject to a threshold– Restructuring

• Under ISDA definitions there are 4 standard options– Full Restructuring

» Reduction in interest or principal» Delay in interest payments» Extension of maturity» Subordination of reference obligation» Restructuring as a result of credit deterioration

– Modified Restructuring» As above BUT deliverable obligation limited to a maximum

maturity, and must be fully transferable


• Credit Default Swaps - What is a credit event?– Modified Modified Restructuring

» As for Modified restructuring BUT deliverable obligation can have a longer maturity than the restructured security and/or some conditional transferability

– Cross Default/Cross Acceleration» No specific failure to pay, but a breach of covenant or other

obligation» Currently rare

• Sovereign Credit Events– Repudiation– Moratorium

• These must be followed by actual failure to pay or restructuring

– Within the later of 60 days or the next reference obligation payment


• Credit Default Swaps - What is a credit event payment?– Fixed Amount (digital)

• An amount to be paid in the case of a credit event is fixed at the outset.– Used in recovery rate swaps

– Physical Delivery• The protection buyer delivers obligations of the reference entity from an

agreed basket with face value of the notional of the trade: the protection seller pays par

– Cash Settled• Default value is determined by a dealer poll and the protection seller pays

the difference between par and the default value on the notional amount of the trade to the protection buyer

– Auction• The are often more CDS outstanding than debt obligations of the reference

entity• To preclude vast artificial turnover, an auction process has been established

to determine the default value, which is then applied across the market.– The terms are too complex to discuss here, but see Markit/Creditex Credit Event

Auction Primer


• What is the reference entity? Or on what is the credit protection?– Reference Entity

• The specific entity subject to the CDS– Mergers/Spin-offs are covered by rules

– Reference Obligations• Used to determine the seniority of the deliverable

obligation– Obligations

• Which obligations can trigger a credit event– All borrowed money

» Including loans, bonds, deposits etc– Bonds and/or loans– A specific security of loan

» e.g. the 5% of 2020


• What is the reference entity? Or on what is the credit protection?– Deliverable Obligations

• What can be delivered by the protection buyer in the case of a credit event

– Bonds, Loans– Maximum maturity– Currency– Etc

– These conditions determine the pool of potential deliverable assets in the case of a credit event, from which the protection buyer will choose the cheapest to deliver.

– The wider the definition, the greater the value of the protection• And the greater its cost


Credit Default Swaps (Recap)

• A Credit Default Swap (CDS) is a contract in which the writer offers the buyer protection against a credit event in a reference name for a specified period of time in return for a premium payment.

• Typical CDS cash flows– The buyer pays a premium quarterly in arrears.– The contract pays par in return for 100 nominal of debt if

the reference name suffers a credit event before the maturity of the deal.

– Note that settlement can take various forms, but as seen above is definitely moving towards an auction procedure

CDS Structure

Protection Buyer

Protection Seller

Quarterly premium in arrears

Protection Buyer

Protection Seller

Defaulted debt of reference name

Par less fraction of premium

Pre-default

Post-default

CDS Example

Protection Buyer

Protection Seller

314.486 bps quarterly in arrears

Protection Buyer

Protection Seller

$1,000,000 plus fraction of premium

Pre-default

Post-default

$1,000,000 ParGMAC

Par Asset Swap Example

Interest Rate Swap

Desk

AS Trading Desk

Investor

Floating Floating payments

+par at maturity

ParFixed

Market

Cash=Bond Dirty PriceFixed CouponCredit Bond

CDS - Asset Swap Hedge

Interest Rate Swap

Desk

AS Trading Desk

Investor/ Protection

Buyer

Floating Floating payments

+par at maturity

ParFixed

Market

Cash=Bond Dirty PriceFixed CouponCredit Bond

Protection Seller

Quarterly premium in arrears and

defaulted debt upon default

Par less fraction of

premium upon default

CDS - Asset Swap Hedge Example

Interest Rate Swap

Desk

AS Trading Desk


Buyer

Market

Protection Seller

$10,000,000 ParGMAC 5 5/8sof 5/15/2009

Floating 3M LIBOR+273.7bps

$10,000,000 initially

Fixed 5.45232% semi-annual

Floating 3M LIBOR+256.8 bps


$10,000,000 less partial premium on default event

$10,000,000 par of GMAC

debt on default event

$9,300,000+$42,187.50=$9,342,187.50

Initial Cash flows

Interest Rate Swap

Desk

AS Trading Desk


Buyer

Market

Protection Seller

$10,000,000 ParGMAC 5 5/8sof 5/15/2009

$9,300,000+$42,187.50=$9,342,187.50

$10,000,000 initially

$719,881

Typical Periodic Cash flows

Interest Rate Swap

Desk

AS Trading Desk


Buyer

Market

Protection Seller

$281,250semi-annually

LIBOR+$68,425 quarterly (approx.

$204,200)

$272,616 semi-annually

LIBOR+$64,200 quarterly (approx.

$200,000)$79,495 quarterly

Cash flows on Default

Interest Rate Swap

Desk

AS Trading Desk


Buyer

Market

Protection Seller

$10,000,000 Pardefaulted

GMAC 5 5/8sof 5/15/2009

$10,000,000 less partial premium

Unwind IR swapUnwind IR swap

$10,000,000 Pardefaulted

GMAC 5 5/8sof 5/15/2009 or similar

Is the Protection Buyer Hedged?

• Upon default, the protection buyer – receives $10m from the protection seller

• and (assuming 40% recovery) – delivers defaulted debt worth $4m.

• At the inception of the contract, the GMAC note was only worth $9.3m. • So the buyer receives a net of $6m from the CDS,

– but has really lost only 9.3-4=$5.3m. So the buyer has too much CDS.

• The correct hedge ratio is given by

• In this case the protection buyer should buy $10m x (.93-.4)/(1-.4)=$8.9m notional CDS to be hedged.

• (Note the assumption of the recovery rate!)

( )

(1 )

bond price RCDS notional bond notional

R

CDS Basis

• A number of factors observed in the market serve to make – the price of credit risk that has been established synthetically using credit

default swaps

• to differ from – the price as traded in the cash market using asset swaps.

• Identifying such differences gives rise to arbitrage opportunities that may be exploited by basis trading in the cash and derivative markets.

• This in known as trading the credit default basis and involves either buying the cash bond and buying a CDS on this bond, or selling the cash bond and selling a CDS on the bond.

• The difference between the synthetic credit risk premium and the cash market premium is known as the basis.

CDS Premium – Z-Spread = basis• (Z-spread = spread vs discount curve/zero-coupon curve)

CDS Basis

Basis=314.486-291.9=22.586

Interest Rate Swap

Desk

AS Trading Desk


Buyer

Market

Protection Seller

$930,000+$4,218.75=$934,218.75

Floating 3M LIBOR+273.7bps

$1,000,000Fixed 5.45232% semi-annual

Floating 3M LIBOR+256.8 bps


$10,000,000 ParGMAC 5 5/8sof 5/15/2009

Z-Spread=291.9

CDS Basis

• The basis is usually positive, occasionally negative, and arises from a combination of several factors, including

– Bond identity: • The bondholder is aware of the exact issue that they are holding in the event of default• However, default swap sellers may receive potentially any bond from a basket of

deliverable instruments that rank pari passu with the cash asset. • This is the delivery option held by the protection buyer

– Depending on the precise reference credit, the CDS may be • more liquid than the cash bond, resulting in a lower CDS price,

– or • less liquid than the bond, resulting in a higher price

– Shorting the bond/asset swap may be expensive or impossible– The CDS events of default may be broader than bankruptcy/failure to pay

• Basket Swaps /Options• Description• A pays B a regular premium (for a swap)/one-off premium

(for an option)• B pays A a set notional amount when (if) the nth (usually the

FIRST) credit event takes place on ANY of the reference entities in the basket

• Result• A is short the credit risk of the whole basket of reference entities• B is long the credit risk of the basket of reference entities• Details• The basket will usually contain between 3 and 10 reference entities• The premium will depend on the number and quality of the credits,

as well as the correlation between the credits.• Note that the LOWER the correlation, the HIGHER the risk of one credit

event (and so the higher the premium)


• Collateralised Debt Obligations (CDOs), and variants

• Description• STANDARD• A pool of bonds or loans is restructured into

tranches: payments from the pool’s cash-flows are first made to the highest rated tranche, then to the second-highest rated tranche etc so that any default is borne by the lower tranches first.

• SYNTHETIC• As above, except that a pool of CDSs is

used instead of cash assets


CDOs

• Original objective to remove assets from balance sheet– And achieve capital relief

• Basic Mechanics– Set up Special Purpose Vehicle (SPV)

• Independent, non-consolidated, bankruptcy-remote• Sole purpose to handle income stream from assets

– i.e. receive funds and distribute to note holders

– SPV holds assets and issues notes backed by these assets– Notes (CDOs) structured in Tranches

• First Tranche = Senior Tranche = AAA• Mezzanine Tranche(s) <AAA but Investment Grade• Lowest Tranche = “Equity”, bears first loss

Generic CDO Structure

CDO Special Purpose

Vehicle (SPV)

Subordinated NotesEquity

MezzanineFixed or Floating Rate

Notes

Senior Fixed orFloating Rate

Notes

Diversified Pool ofUnderlying Assets

(Collateral)

Collateral Manager

CDOs

• Basic Mechanics– If losses on the assets held by the SPV occur

• They are applied first to the “Equity” or lowest tranche– Which reduces in size

– If losses outgrow the size of the Equity tranche• They are applied to the next lowest tranche

– And so on– INCOME flows to the Senior tranche first and then DOWN– LOSSES flow to the Lowest tranche first and then UP– Note : the Equity tranche is usually retained by the

originator

CDOs

• Rating the Tranches– The ratings agencies each have models for evaluating

CDOs• See their web sites for further details

– The key parameters for rating are• Quality of underlying assets

– Actual ratings apply BUT– If there is no rating for a particular asset going into a CDO

» The rating agency may apply a “shadow” rating » Or may rely on mapping the originators internal rating

• Diversification of underlying assets– Moody’s and S&P rely on geographical and industry categories– Fitch looks to equity correlations

CDOs

• Rating the Tranches– Key Parameters

• Subordination structure of the tranches– The larger the size of tranches below a given tranche

» The more protection the given tranche has (since losses apply first to the ones below)

» And the higher the rating

• Additional Credit Enhancements– Credit Insurance

» e.g. from monoline

– Credit derivative

Synthetic CDOs

• Basic Mechanics– Tranche system is the same as with standard CDOs

• Senior through Mezzanine to Equity

– But proceeds of the Notes (tranches) used to • Purchase high-quality assets (collateral)

– Which fund notes issued

• Purchase portfolio of CDS from originator– i.e. SELL protection to originator– CDS premium also goes to funding notes

– Effect is same as with standard CDO• Less expensive and faster than using physical assets

– In the case of a credit event• SPV sells collateral to pay originator• And reduces size of relevant tranche

– Equity tranche reduced first and so on

Partially Funded Synthetic CDOs

• Senior Tranche is very large (80%+)– Known as “Super Senior”– Effective rating HIGHER than AAA– Retained by originator

• Only Mezzanine tranches are sold to investors– Proceeds retained to purchase high-quality collateral

• CDS only created for tranches sold• Specialised CDS Tranches from Credit Indices

– See below

Partially Funded Synthetic CDOs

• Example– $100 million underlying

• $5 million in Equity tranche• $80 million in Super-Senior Tranche

– $15 million Mezzanine Tranche– CDS covering losses beyond the first 5% loss– and up to 20% loss– Loss coverage of 15%– Which constitutes credit exposure of Mezzanine tranches

Static vs.. Managed CDOs

• Original CDOs were static– i.e. the underlying portfolio essentially unchanged for

life of CDO

• CDOs now largely managed• Manager can typically

– Trade portfolio assets• Up to a predefined level

– e.g. 5% per annum– Buy additional protection on deteriorating credits held– Sell swaps that have increased in value– Replace positions for higher spreads

• Time liquidation of defaulted assets – To maximise recovery rates

• CDO Managers now largely specialised third-party– i.e. NOT originating bank– Own the Equity tranche– Generate excess spread

• Moral Hazard– Will the managers restructure portfolio to own advantage

• And to detriment of other tranches?– Senior tranches want higher diversification=lower correlation of assets

• Higher chance of smaller loss– Absorbed by Equity tranche (etc)

– Equity tranche wants lower diversification=higher correlation of assets• Lower chance of higher loss

• Answer:– Reserve pool accumulates excess spread

• Offsets excess credit losses• Only excess spread NET OF LOSSES accrue to Equity tranche

Static vs.. Managed CDOs


• Credit Indices– Description

• 1] Corporate indices• 2] CDS indices

– Result• Buyer is long (more or less general) credit• Seller is short (more or less general) credit

– Details• Constituents of Indices and their tranches

change– Corporate index constituents change

every month– Exclusively rules-based– CDS index constituents change every 6

months– Based on liquidity

recommendations from active dealers

Credit Indices

• Two groups of banks independently formed companies to create and market indices of CDS prices in 2003

• Now merged, and currently (!) Markit• Two PRIMARY indices

– North American Investment Grade– European Investment Grade– Each consists of 125 most liquid CDS reference credits– Composition reviewed twice a year (“the roll”)

• Changed to reflect liquidity

– New Indices constantly under development

• Basic Mechanics– Each series has a fixed spread for the life of the index– Current pricing reflected by exchanging the difference

between current price and fixed spread• Fixed spread is 50bps, current price 53bps

– Protection buyer pays up-front (53 – 50 =) 3bps– Protection buyer pays annual fixed spread

» To Protection seller

• Fixed spread is 50bps, current price is 46bps– Protection Buyer receives up-front 4bps

» From Protection seller

– Protection buyer pays annual fixed spread» To Protection seller

Credit Indices

• Basic Mechanics– On default of one of the Reference credits in the index

• Protection buyer delivers securities– Face amount of 1/125 (i.e. 0.8%) of notional value of trade– To protection seller

• Protection seller pays 0.8% of the notional trade– To protection buyer

• Notional on the trade reduced by 0.8%

• Tranches– Index traded whole– OR in standardised tranches

• Designed to look like those of a CDO– Described in percentage of loss terms

» e.g. 7%-10% tranche of NAIG covers losses on the NAIG index greater than 7% and up to 10%

Credit Indices

• The Tranche structure– Greatly facilitates the creation and hedging of CDOs– Require highly sophisticated models to value and trade– Have complex interrelational dynamics– Default and Recovery assumptions key

• Correlation:– Default correlation among constituent reference credits

key valuation assumption• INCREASE in correlation

– INCREASE expected losses in Senior tranches» So value of protection increases

– DECREASE expected losses in Equity tranche» So value of protection decreases

Credit Indices

• Specific• Implementing a view on the creditworthiness of a specific sector• In general• Long or short a CDS Index• vs. another sector• Long or short a CDS Index vs. another• Implementing a view on the creditworthiness of a specific issuer• In General• Long or short a specific CDS• “Selling” insurance = going long of the credit• “Buying” insurance = going short the credit • vs. Another• Long CDS on one credit vs. short CDS on another

credit• Credit Pair Trades• 1] Carry Trade• 2] Directional trade• Implementing a view on the capital structure of one credit• e.g. Senior vs. Subordinated• or Convertible vs. Straight

Using credit instruments practically

PARMALAT

Parmalat Finanziara SpAParmalat Finanziara SpA

Parmalat SpAParmalat SpA

Parmalat Finance Corp BVParmalat Finance Corp BV

(single guarantee from Parmalat SpA)

€650mm 6.25% ’05

€350mm 6.125% ‘10

Parmalat Netherlands BV Parmalat Netherlands BV

(guaranteed by Parmalat SpA and Parmalat (guaranteed by Parmalat SpA and Parmalat Finanziara SpA)Finanziara SpA)

€€350mm CB 0.875% ’21350mm CB 0.875% ’21

Parmalat Capital Netherlands BVParmalat Capital Netherlands BV

(Single guarantee from Parmalat (Single guarantee from Parmalat Finanziara SpA)Finanziara SpA)

€€281mm CB 1% ‘05281mm CB 1% ‘05

Other Subsidiaries

Non-directional pair trade – profit from volatility without directional risk

PARMALAT

• 11/12/03 : Long €1mm Parmalat CB 0.875% ’21 @ 62 – 0.4 accrued• 11/12/03 : Short €1mm Parmalat 6.25% ’05 @ 64 + 5.5 accrued

• Performance of the pair trade in a bankruptcy scenario.• Base Recovery Rate (RR) for bondholders assumed to be @ 15%

• Double Guarantee on CB 0.875% 2021 increases RR to 30% in best case outcome.

• Accrued Interest pickup = 5.1 points

• Expected Return (Worst Case: both bonds RR @15%) = 2 + 0 + 5.1 = 7.1 points

• Expected Return ( Best Case: double guarantee gives full 30 point value) = 2 + 15 + 5.1 = 22.1points


PARMALAT

Parmalat Pair Trade

0

40

80

120

Date

Px

Parfin 6.25 '05 Parfin CB 0.875 '21

Short coveredShort covered

Long / Short

•Trade Unwind•Non-directional pair trade

•Long Parmalat CB 0.875% ‘21 @ 62

•Short Parmalat 6.25% ‘5 @ 64

•Accrued Interest pickup = 5.1 points

•Parmalat files for Bankruptcy on 19/12/03

• Long / Short unwound @ Px of 24 & 20

•Profit: (24-62) + (64 – 20) +5.1= 11.1 points

•On €10mm, Gross Profit = €1.11mill.


• Opportunistic• Basis packages: specific arbitrage opportunities• Synthetic vs. real bond• Basis packages are the purchase (sale) of specific credit

exposure in the cash market and the simultaneous sale (purchase) of the same risk in the CDS market, ideally at two different prices.

• Two “basic” basis strategies.

1] A “negative basis” package strategy (buy bond and buy protection) is typically motivated by a relatively low spread in the CDS market relative to comparable cash bond spread (i.e., an attempt to earn a risk-less return by buying and selling the same credit in different markets).

2] A “positive basis” package strategy (sell bond

and sell protection) is the opposite — an attempt to take advantage of a relatively high CDS spread relative to the cash market.

Using credit instruments practically

Hedging S&P Exposure with CDX

Pros and cons of hedging with CDX Indices

•Historical relationship (2005-2007)

•How correlation has evolved in recent months

•Performance during major sell-offs

Estimate the “appropriate” hedge ratio

Correlation between stocks and credits (Example: S&P 500 and CDX HY)

Real world experience: S&P 500 and CDX HV9 – performance since the last roll

Pros and cons of hedging with credit indices

What the CDX indices can do:

•One way to hedge against “tail risk”

• – CDX indices provide an effective hedge against a sharp and unexpected decline in the stock market

•A potential P&L driver

• – CDX indices allow equity investors to profit from the diverging trends in the equity and credit markets

What the CDX indices cannot do:

•Not a perfect hedge

• – Using credit indices to hedge equity exposure entails basis risk

•Not always the cheapest hedge

• – Equity futures, ETF, options collars may provide cheaper ways to hedge a long equity position

-20%

-10%

0%

10%

20%

30%

1/05

3/05

5/05

7/05

9/05

11/0

5

1/06

3/06

5/06

7/06

9/06

11/0

6

1/07

3/07

5/07

7/07

9/07

11/0

7

1/08

(bp)

-200

-100

0

100

200

300

Correlation between S&P 500 and CDX HY Index

Source: UBS, Bloomberg

Cumulative change: S&P 500 and HY CDX Index

Correlation: – 0.7

S&P 500

HY Index

(left axis)

(right axis)

How correlation has evolved over time


S&P 500 (X-axis) and Cumulative Change in CDX HY Index (Y-axis), 2005 - 2007

-200

-150

-100

-50

0

50

100

150

200

1000 1100 1200 1300 1400 1500 1600 1700

Even though spread volatility has gone up in 2H07, correlation between stocks and credits remain quiet strong

(bp)

-20%

-10%

0%

10%

20%

30%

1/05

3/05

5/05

7/05

9/05

11/0

5

1/06

3/06

5/06

7/06

9/06

11/0

6

1/07

3/07

5/07

7/07

9/07

11/0

7

1/08

-200

-100

0

100

200

300

Correlation spikes during market sell-offs


Cumulative change: S&P 500 and HY CDX Index

S&P 500

HY Index

(left axis)

(right axis)

What about hedge ratio?

Given the strong negative correlation between stocks and credits, the CDX HY Index seems like a reasonably good hedge against “tail risk”…

… but what is the appropriate hedge ratio?

… if you are long $10mm of stocks, how much HY should you short?

Estimate the appropriate hedge ratio: Historical correlation


S&P 500 (X-axis) and Cumulative Change in CDX HY Index (Y-axis), 2005 - 2007

-200

-150

-100

-50

0

50

100

150

200

1000 1100 1200 1300 1400 1500 1600 1700

(bp)

–100

+120

2H07

2005 – 1H07

Estimate the appropriate hedge ratio: Focus on the big sell-offs


S&P 500 and HY Index week-over-week performance comparison

-4.7%

-3.5%

-2.5%

-1.4%

-0.5%

0.5%

1.4%

2.4%

3.4%

4.4%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Down

>4%

Down

3-4%

Down

2-3%

Down

1-2%

Down

0-1%

Up 0-

1%

Up 1-

2%

Up 2-

3%

Up 3-

4%

Up >4%

S&P 500 average 1-week change in % (left axis)61

3225

12

3

-3-7

-20

-30

-48

-75

-50

-25

0

25

50

75

HY Index average 1 change in bp (right axis)

– Hedge ratio should be about 2.1 times (4.7%/2.2%)

3) Estimate the appropriate hedge ratio

– $217,160 / $10,000,000 = 2.2%– $3,560x 61= $217,160– It widened an average of 61bp

2) Estimate the expected performance of the HY Index during majorr sell-offs

– HY9 would result in a profit of about $3,560– That means for every 1bp of widening, a $10mm short position inthe – HY CDX9 has a DV01 of about $3,560 for $10mm of notional exposurere

1) Find the DV01 of the HY Index

Hedge ratio

– Hedge ratio should be about 2.1 times (4.7%/2.2%)

3) Estimate the appropriate hedge ratio

– $217,160 / $10,000,000 = 2.2%– $3,560x 61= $217,160– It widened an average of 61bp

2) Estimate the expected performance of the HY Index during majorr sell-offs

– HY9 would result in a profit of about $3,560– That means for every 1bp of widening, a $10mm short position inthe – HY CDX9 has a DV01 of about $3,560 for $10mm of notional exposurere

1) Find the DV01 of the HY Index

Hedge ratioS&P 500 average 1-week change in %

-75

-50

-25

0

25

50

75

HY Index average 1 change in bp

Down

>4%

Down

3-4%

Down

2-3%

Down

1-2%

Down

0-1%

Up 0-

1%

Up 1-

2%

Up 2-

3%

Up 3-

4%

Up >4%

Estimate the appropriate hedge ratio: Focus on the big sell-offs


Focus on the “tail”

-4.7%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%61

Real world example:


If you went short HY9 in October against a long position in the S&P, how would you have done?

1375

1425

1475

1525

1575

4/07 5/07 6/07 7/07 8/07 9/07 10/07 11/07 12/07 13/07

Real world example: P&L estimate

-$800,000

-$400,000

$0

$400,000

$800,000

$1,200,000

9/27/07 10/11/07 10/25/07 11/8/07 11/22/07 12/6/07 12/20/07 1/3/08

Total P&L

Long S&P 500 ($10mm notional, P&L includesdividend received)Short HY9 ($22mm notional, P&L includespremium paid)

Gains from the short HY position more than offset the losses in equities


Lessons from the recent credit market turmoil

• If it’s too good to be true, it probably isn’t true• When a new asset class is securitised, what is the historical data for• Default probability?• Recovery rate? Etc?• Sub-prime mortgages could not realistically be modelled using existing data• Importance of liquidity• Liquidity is essentially subjective• i.e. it can change with market perceptions• Usually straightforward to ESTIMATE relatively• i.e. a UST is more liquid than a AAA• and AAA more liquid than BBB etc• There are also rules of thumb:• Size of issue• Age of issue• Number of traders (the 2” rule)• BUT there can be unexpected (and unpredictable) effects• e.g. interbank liquidity• Note : LIBOR became illiquid, but not EONIA

credit default swaps (cds) /options description a pays b a regular premium (for a cds)/one-off...

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