By Merrill Lynch
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Additional resources for Credit Derivatives Handbook - Volume 1
At initiation, the PV of all the cashflows must be zero. As such, the asset swap spread satisfies the following equation (from the perspective of the asset swap seller): M Fixed payments on IR swap 0 = 100−P + ∑ M C×di − i=1 ∑ (L +A)×d ×α i i i i=1 Floating payments on IR swap Where, P is the cash price of the bond, A is the Par-ASW spread, di is the ith discount factor (derived from swap market), Li is the ith LIBOR rate set at time ti-1 and paid at time ti, C is the bond’s coupon, αi is the accrual factor in the appropriate daycount basis.
Refer to important disclosures on page 118. 31 Credit Derivatives Handbook 2006 – Vol. 1 – 14 February 2006 • Investor expects a credit event after that implied by the market: The investor would prefer to (a) sell protection on a running basis, or (b) buy protection on an upfront basis. Table 12: Relative Performance of an Upfront and Running CDS as a Function of Credit Event Timing Protection Buyer Prefers Credit Event in the Credit Event in the Near-Term Longer-Term × × Upfront CDS Running CDS Protection Seller Prefers Credit Event in the Credit Event in the Near-Term Longer-Term × × Source: Merrill Lynch Case Study: Basis Trading With Upfront CDS Upfront CDS can also be used in basis strategies .
Each cash flow is discounted at the appropriate rate based upon when it will be paid. To say it another way, Z is the single number which, when added to each point on the swap curve, produces a discount curve that yields the current price of the bond when used to discount all the bonds cash-flows. This number is calculated through an iterative process. Because it uses the entire yield curve to value the cash flows rather than just a Refer to important disclosures on page 118. 41 Credit Derivatives Handbook 2006 – Vol.