Historic Default Rates And The Risk Of CDS Indices & Tranches

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Historic Default Rates and the Risk of CDS Indices & TranchesProfile image of Douglas J LucasDouglas J Lucas

2008

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17 pages

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What can historic default rates tell us about the risk of credit default swap indices and tranches? In this CDO Insight, we calculate “fair prices,” i.e., index and tranche premiums such that the present value of premiums exactly equals the present value of expected credit event payments. We calculate different breakeven prices using default and recovery rates from three different historic periods: • an equal weighting of historical experience 1970-2007; • the worst default experience within 1970-2007, i.e., 1986-1990 for investment-grade credits and 1989-1993 for the speculative-grade credits; • the nadir of the Great Depression, 1932-1936. Default rates are input as default probabilities into a simulation model that allows for default rate volatility. Historic recoveries are input into the model to produce recovery distributions. Our analysis covers the five-year tenors of the following indices and their tranches: North American investment grade (CDX NA IG), North American high yield (CDX NA HY), and European investment grade (iTraxx).

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