Capturing Credit Default Swaption Trades

This document describes how to capture Credit Default Swaption trades using the Credit Default Swaption worksheet.

A credit default swaption is an option on a credit default swap.

Choose Trade > Credit Derivatives > Credit Default Swaption to open the Credit Default Swaption worksheet, from Calypso Navigator or from the Trade Blotter.

Credit Default Swaption Quick Reference

When you open a Credit Default Swaption worksheet, the Trade panel is selected by default.

Entering Trade Details

You can select a template from the Template field to populate the worksheet with default values. Then modify the fields as applicable.

Enter trade details in the Trade panel.

Note that the Trade Date is entered in the Details panel.

Proceed to the other panels as applicable.

For defining break clauses, choose .

Saving a Trade

Hit F5 to save the trade, or choose .

You can also hit F3 to save the current trade as a new trade, or choose Trade > Save As New.

You can also hit F12 to save the trade using any action available in the workflow, or choose Trade > Save Action. You will be prompted to select an action.

A description will appear in the title bar of the trade worksheet, a trade Id will be assigned to the trade, and the status of the trade will be modified according to the workflow configuration.

Pricing a Trade

You can choose to check if all required pricing data are available in the Pricing Environment.

Click Price to price the trade.

Hit F9 to bring up the solver (or choose ).

Select a target pricer measure and enter the target value. Then select the value to solve for (fixed rate, upfront fee, or notional), and click Solve.

You can click Apply to set the value to solve for on the trade. Then click Price to obtain the target value.

You can modify the solver variables and details as needed.

Trade Lifecycle

You can exercise the swaption using , or using the AUTOMATIC_EXERCISE scheduled task.

You can allocate the trade to multiple books using .

You can terminate the trade using .

You can define and apply credit events using .

See also - All Trade Menus for information on functions, menus and panels common to all trade windows.

1. Sample Credit Default Swaption Trade

Enter option details in the Trade panel - They are described below.

The enter more trade details as described in the documents below, based on the CDS type:

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Capturing CDS Trades for a Single Name credit default swaption.

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Capturing CDS Nth Default Trades for a Nth Default credit default swaption.

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Capturing CDS NthLoss Trades for a Nth Loss credit default swaption.

2. Trade Panel - Fields Description

Option Details

Fields	Description
Trade Type	Select the type of trade from the first field: Option, Extendible, or Cancellable.
CDS Type	Select the type of CDS from the adjacent field: Single Name, Nth Loss, or Nth Default.

Fields

Description

Settlement

Select the settlement type: Cash or Physical.

1D Bus NYC

(delivery lag)

Double-click the delivery lag to specify the number of days between the expiration date and the delivery date. It brings up the OptionCalcDialog.

Select the holiday calendar.

Enter a number of lag days, months or years in the Offset field.

Days lag “D” can be business days or calendar days. Double-click the Bus label to switch to Cal as needed.

For months lag “M” and years lag “Y”, the system uses calendar days only.

The “No Tenor” checkbox only applies to days lag, when you enter more than 31 days. If you check the “No Tenor” checkbox, the offset will not be converted to a tenor, as shown below for 35D.

Otherwise it will be converted to a tenor. Note that the conversion is for display only. The system always stores 35D.

For Bermudan options, select the frequency of the exercise dates.

BUY/SELL

Direction of the trade from the book’s perspective. Double-click the BUY label to switch to SELL as applicable.

RTP/RTR/Straddle

Direction of the option. Double-click the RTP label to switch to RTR or Straddle as applicable.

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RTP (right to pay premium)

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RTR (right to receive premium)

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Straddle (a simultaneous RTP and RTR at the same strike and maturity)

Ex Type

Select the exercise type: European, Bermudan, or American.

European

The option can only be exercised on the expiration date.

Enter the expiration date in the Expiry field. The background color will change if the date is not a business day. You can double-click the Exp Dt label to roll the date to the previous business day.

Bermudan

The option can be exercised according to a user-defined schedule.

Double-click the red label to specify the exercise schedule. You can also choose .

Click Add to add an exercise date as needed, and enter the expiration date and the delivery date.

Then click Apply.

American

The option can be exercised within a date range.

Enter the first exercise date in the 1st Exercise field, and the last exercise date in the Expiry field. The option can be exercises between those two dates. The background color will change if the date is not a business day.

Expiry Time

The red label next to the Expiry date displays the expiry time and timezone. Double-click to bring up the Exercise Timing Details window. You can also choose CDS Index Option > Exercise Timing Details.

Enter the expiration times and select the timezone as needed.

Then click Apply.

Rec Prem/Pay Prem

Direction of the option’s premium fee from the book’s perspective. Double-click the “Rec Prem” label to switch to “Pay Prem” as needed.

Select the currency from the adjacent field, and enter the premium fee amount in the adjacent field.

Prem Date

Enter the payment date of the option’s premium fee.

Then click Add to create the option’s premium fee. It is displayed in the Fees panel.

The premium fee is a fee of type PREMIUM. Such a fee needs to be defined in Calypso Navigator > Configuration > Fees, Haircuts, & Margins > Fee Definition.

Auto Exercise

Check the “Auto Exercise” checkbox to allow automatic exercise. Options can be automatically exercised using the AUTOMATIC_EXERCISE scheduled task, provided they are in-the-money.

Otherwise, choose Back Office > Exercise to exercise the option. Help is provided from that window.

Knockout/Acceleration

Select the method for handling credit events:

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Knockout – If a credit event occurs on the underlying during the option’s period, the option will be terminated at the credit event date.

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Acceleration (No Knockout) – If a credit event occurs on the underlying during the option’s period, the option can be exercised between the credit event date and the expiration date.

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No Acceleration (No Knockout) – Credit events on the underlying have no impact on the option.

2.1 Payout Value

On the expiration date, the swaption can be exercised either into a physical CDS or settled for cash. For cash settlement, the value of the swaption is, if for the right to pay premium:

CD Swaption Payout = Max[(Current CDS NPV) – (Swaption Underlying CDS NPV), 0)

Because the underlying CDS has the same value of credit default leg (reference asset leg) no matter what the current CDS spread, the swaption value only depends on the net value of its premium leg. The premium leg is valued for a CDS by discounting each cashflow using the risk-free curve and multiplying by the probability that the cashflow will be paid, i.e., that the reference asset has not defaulted. If the current credit spread is S and the strike K then a swaption to pay premium has:

Here N is the notional amount, a_i the accrual time of the ith cashflow, and B(t_i) is the "risky" discount factor, the riskless discount factor times the survival probability. The computation of the risky discount factor is the same as done when pricing a credit default swap.

2.2 Pricing Method

There is a standard method for pricing European credit default swaptions using a formula analogous to the Black-Scholes formula for pricing of European interest-rate swaptions. Currently Calypso only implements the Black-Scholes-style formula, as described in this document.

This method is only applicable to swaptions:

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European exercise

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Underlying CDS has a fixed premium leg (not floating)

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Underlying CDS is a single-name asset (not a basket).

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The Calypso class that implements this method is PricerCreditDefaultSwaption.

2.3 Pricing Formula

If one assumes lognormal volatilities for CDS spreads, the Black-Scholes equation can be used with little modification. The differences from the evaluation of interest-rate swaptions are:

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The annuity factor, the sum of the discounted cashflows per unit interest rate, is computed using the risky discount factors, as described above.

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The forward rate is calculated for the underlying credit default swap using the valuation method in PricerCreditDefaultSwap.

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The volatility is obtained from a volatility surface for CDS spreads.

The formula for a swaption to pay premium is then: