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Structured Finance and the Financial Turmoil of 2007 2008

4 the list of credit events in a cds contract may

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4 . The list of credit events in a CDS contract may include one or more of the following: Bankruptcy or insolvency of the reference entity, failure to pay an amount above a specified threshold over a specified period and financial or debt restructuring.
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BANCO DE ESPAÑA 34 DOCUMENTO OCASIONAL N.º 0808 Chart 9. Single-name CDS of international banks Chart 10. Single-name CDS of Bear Stearns and implied probability default In addition to single-name contracts, the CDS market is characterized by the existence of index contracts. A credit default swap index contract can be interpreted as an insurance contract covering the default risk of the pool of debt instruments issued by the group of companies on which the index is based. Essentially, a CDS index contract is a private OTC transaction that enables investors to take synthetic exposures or protection on a large CHUDQRHjDC and standardized basket of reference entities, which may be as many as 125 corporate entities [Citigroup (2006b); #TEjD (2007)]. The index contracts are standardized in terms of the index composition procedure, premium payment and maturity, and consequently are more liquid than single-name contracts. Thus, CDS index contracts are traded at a smaller bid-offer spread because it is cheaper to hedge a portfolio of bonds with a CDS index contract than to buy the single name CDS of all bonds included in the index. The composition of the index (i.e. the speci jB reference entities included in the index) is rebalanced, or “rolled over” (on the so-called “roll” day), each six months (March and September) based on the vote of participating dealers in accordance with the index rules to ensure that the index is up to date regarding the underlying reference entities. The LNCHjDC index will be “on-the-run for the next six months, while the “off-the-run” CDS index contract (with the “old” composition) remains static for the rest of its lifetime if no defaults occur of the underlying reference entities. There are two kinds of CDS index contracts, i.e. unfunded (so-called “multi-name” CDS) and funded contracts (which are based on so-called Credit Linked Notes) [BIS (2005b)]. The RODBHjBR of unfunded and funded contracts are beyond the scope of this paper. For more spec HjB information see for example Chacko et al. (2006), BIS (2005b) and Mengle (2007). Currently, there are two main families of standardized CDS index contracts that appeared in 2004 and which are marketed by the Markit Group 5 , i.e. the Dow Jones CDX and 5 . The Markit Group is owned by 16 large investment banks. PANEL B. European banks 0 50 100 150 200 250 300 350 400 450 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 BNP Paribas Deutsche Bank Barclays Bank UBS Santander BBVA pb PANEL A. US Investment Banks 0 50 100 150 200 250 300 350 400 450 Merrill Lynch Goldman Sachs JP Morgan Morgan Stanley Lehman pb PANEL B. Implied probabilities of default of Bear Stearns 0% 2% 4% 6% 8% 10% 12% May-07 Jul-07 Sep-07 Nov-0 Jan-08 Mar-08 0% 10% 20% 30% 40% 50% 60% BS PD 1y BS PD 5y PANEL A. Bear Stearns CDS spread 0 100 200 300 400 500 600 700 800 900 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 pb SOURCE: Datastream.
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