I missed that one early, but it’s a good read.
This paper is not meant as a criticism of the proposed standardization of the conversion method but as a warning on the confusion this may generate when the method is not used carefully.
Charting a Course Through the CDS Big Bang, from Fitch:
The proposed flat hazard rate (FHR) conversion method is to be understood as a rule-of-thumb single-contract quoting mechanism rather than as a modelling device.
For example, an hypothetical investor who would put the FHR converted running spreads into her old running CDS library would strip wrong hazard rates, inconsistent with those coming directly from the quoted term structure of upfronts.
This new methodology appears mostly as a device to transit the market towards adoption of the new upfront CDS as direct trading products while maintaining a semblance of running quotes for investors who may be suffering the transition. We caution though that:• the conversion done with proper hazard rates consistent across term would produce different results;
• the quantities involved in the conversion should not be used as modelling tools anywhere;
• for highly distressed names with a high upfront paid by the protection buyer, the conversion to running spreads fails unless, as we propose, a third recovery scenario of 0% is added to the suggested 20% and 40%.
When the upfront is very high, the conversion method fails to produce a corresponding positive running spread if ( upfront + fixed recovery ) is larger than 1. The only possibility to get a positive flat hazard rate to do the conversion is to lower the recovery rate.
You can test that for yourself here, enter an upfront > (1-R) i.e 61 for Snr with R= 40%, and there is no (positive) running spread with FHR.
Related:
The CDS Big Bang