Problems & Solutions: Recovery Swaps and CDO Deltas

Michael Ong

Abstract

1. Recovery Swaps

Recovery swaps are the most recent innovation in the credit derivatives market. In this contract, two counterparties agree to exchange the realized recovery vs. the preset recovery value (recovery swap rate) in case of default, with no other payments being made in any other scenario. They allow investors to eliminate the uncertainty of the future recovery payment which is present in the conventional (ie, floating recovery) CDS, whose protection payment in case of default depends on the post-default price of the reference obligation. Given the large uncertainty about recovery rates, and their importance for calibration of most credit derivative models, how will the introduction of this contract impact the practice of credit derivatives modeling? How does the "credit triangle" relationship look in the presence of traded recovery swaps? How should investors price this product and evaluate its relative value?

Editor's note: Arthur Berd will present his market insights on this new topic in the Credit Risk Forum section in the next issue.

2. CDO Deltas

In synthetic CDO markets, many market participants price tranches using base correlations, as implied from tranches on standard indices such as I-Traxx and I-Boxx. For hedging purposes, it is of interest to consider how the base correlation curve will move with changes in default spreads, but so far few empirical data are available. What are the implications for hedges against spread moves, and can standard models for the correlation skew help out here?

Editor's note: In the next issue, Leif Andersen and Jakob Sidenius present some practical suggestions on how to tackle this important dilemma.