Comments on: AIG and the “Negative Basis” http://www.aleablog.com/aig-and-the-negative-basis/ Alea Jacta Est Wed, 20 Aug 2008 16:37:33 +0000 http://wordpress.org/?v=2.6.1 By: Alea | Exchange-Traded Credit Default Swaps ? http://www.aleablog.com/aig-and-the-negative-basis/#comment-1157 Alea | Exchange-Traded Credit Default Swaps ? Tue, 13 May 2008 12:53:46 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-1157 [...] For a spread, there is more than one price and for a price there is more than one spread. The price of a CDS is always uncertain. There is no single answer, CDS trade on “spreads” but the price depends on models and inputs. [...] [...] For a spread, there is more than one price and for a price there is more than one spread. The price of a CDS is always uncertain. There is no single answer, CDS trade on “spreads” but the price depends on models and inputs. [...]

]]> By: jck http://www.aleablog.com/aig-and-the-negative-basis/#comment-670 jck Thu, 14 Feb 2008 20:29:22 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-670 Gary: There is no market price, it's all model derived. They were using implied spreads on the cash CDOs and implied spreads on the CDS of the CDOs to derive a negative basis which has the benefit of reducing x the super senior cds premium to something < x , hence the benefit of spread differential. If you look at note 6, they start their modelling from the asset side of the CDO to get to spreads on the tranches. There is huge model risk here particularly on the correlation side. Gary:
There is no market price, it’s all model derived. They were using implied spreads on the cash CDOs and implied spreads on the CDS of the CDOs to derive a negative basis which has the benefit of reducing x the super senior cds premium to something < x , hence the benefit of spread differential.
If you look at note 6, they start their modelling from the asset side of the CDO to get to spreads on the tranches. There is huge model risk here particularly on the correlation side.

]]> By: Gary http://www.aleablog.com/aig-and-the-negative-basis/#comment-668 Gary Thu, 14 Feb 2008 19:06:00 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-668 jck: Sure, I understand premiums are rising but here are the two prices they're looking at: X = "fair value" assuming no negative basis, and X-A = market price. They are marking to market and then stating that these writedowns wouldnt occur if the adjusted for negative basis (marked to X instead of market). If they're short protection and X > X-A, how can they possibly show greater MTM by marking to X? Obviously I'm misunderstanding something jck: Sure, I understand premiums are rising but here are the two prices they’re looking at: X = “fair value” assuming no negative basis, and X-A = market price. They are marking to market and then stating that these writedowns wouldnt occur if the adjusted for negative basis (marked to X instead of market). If they’re short protection and X > X-A, how can they possibly show greater MTM by marking to X?

Obviously I’m misunderstanding something

]]> By: jck http://www.aleablog.com/aig-and-the-negative-basis/#comment-659 jck Wed, 13 Feb 2008 10:48:10 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-659 ed: I would add that coupons are paid in arrears so that if you were to short at 4000 bp, you could end up having to pay (1-recovery) without having received a single premium if default happens before the first coupon is due. This is not possible any more, if a company is under threat of imminent default, CDS will trade at a fixed coupon usually 500 bp plus an upfront fee. ed:
I would add that coupons are paid in arrears so that if you were to short at 4000 bp, you could end up having to pay (1-recovery) without having received a single premium if default happens before the first coupon is due. This is not possible any more, if a company is under threat of imminent default, CDS will trade at a fixed coupon usually 500 bp plus an upfront fee.

]]> By: jck http://www.aleablog.com/aig-and-the-negative-basis/#comment-658 jck Tue, 12 Feb 2008 22:30:39 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-658 Shorting doesn't close the position. The exemple given is about a long protection buyer who wanted to unwind [close] the position rather than shorting which is a new position. A dealer could have quoted for an unwind anything between 1% and over 50% of par depending on his view of recovery. At 99% recovery, he would have paid 1% of par to unwind and the protection buyer would have lost since he paid 250 bp/year for 100 bp final pay-off. This didn't happen, it's just an exemple to show that the value of a CDS is dependent on models and inputs and that with a given spread there is no such thing as a unique solution for pricing a CDS. In any case Marconi went bust and recovery was about 30%, so the buyer could have gone buy the bonds at recovery price of 30 and deliver to get par so he made money. Shorting doesn’t close the position. The exemple given is about a long protection buyer who wanted to unwind [close] the position rather than shorting which is a new position. A dealer could have quoted for an unwind anything between 1% and over 50% of par depending on his view of recovery. At 99% recovery, he would have paid 1% of par to unwind and the protection buyer would have lost since he paid 250 bp/year for 100 bp final pay-off. This didn’t happen, it’s just an exemple to show that the value of a CDS is dependent on models and inputs and that with a given spread there is no such thing as a unique solution for pricing a CDS.
In any case Marconi went bust and recovery was about 30%, so the buyer could have gone buy the bonds at recovery price of 30 and deliver to get par so he made money.

]]> By: ed http://www.aleablog.com/aig-and-the-negative-basis/#comment-656 ed Tue, 12 Feb 2008 22:06:52 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-656 How are recovery rates assumptions independent of spreads? I don't understand how a trader long protection at 250bps doesn't make money by closing it out by shorting at 4000bps. How are recovery rates assumptions independent of spreads? I don’t understand how a trader long protection at 250bps doesn’t make money by closing it out by shorting at 4000bps.

]]> By: jck http://www.aleablog.com/aig-and-the-negative-basis/#comment-655 jck Tue, 12 Feb 2008 17:47:31 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-655 Well, the premium aren't falling at the moment, they are going through the roof...that's the problem. Well, the premium aren’t falling at the moment, they are going through the roof…that’s the problem.

]]> By: Gary http://www.aleablog.com/aig-and-the-negative-basis/#comment-654 Gary Tue, 12 Feb 2008 17:21:57 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-654 If they're short CDS and premium falls, shouldn't they be marking greater profits assuming recovery rate doesn't change? Everything else is clear to me If they’re short CDS and premium falls, shouldn’t they be marking greater profits assuming recovery rate doesn’t change? Everything else is clear to me

]]> By: jck http://www.aleablog.com/aig-and-the-negative-basis/#comment-650 jck Tue, 12 Feb 2008 11:51:28 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-650 Jason: Correct and corrected, thx. Jason:
Correct and corrected, thx.

]]> By: Jason http://www.aleablog.com/aig-and-the-negative-basis/#comment-648 Jason Tue, 12 Feb 2008 11:28:04 +0000 http://www.aleablog.com/aig-and-the-negative-basis/#comment-648 Negative Basis .. is where you buy the bonds and then buy protection... so using your example of LIBOR + X on the bond... the CDS quote (i.e. where you can buy protection) is LOWER than X (let's call that Y) .. so that means you can own a bond, and own protection on that same bond .. with positive carry which is X - Y Negative Basis .. is where you buy the bonds and then buy protection… so using your example of LIBOR + X on the bond… the CDS quote (i.e. where you can buy protection) is LOWER than X (let’s call that Y) .. so that means you can own a bond, and own protection on that same bond .. with positive carry which is X - Y

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