Loan CDS, Cancelability and the Basis

Abstract

In our third paper, we return to the pricing of credit derivatives. Luis O’Shea examines the relatively new market for loan-only credit default swaps (LCDS). After introducing this derivative and discussing a few salient differences between LCDS and traditional corporate CDS, Luis presents a number of pricing frameworks. He shows that even after adjusting for the most obvious difference between LCDS and CDS - that is, that the expected recovery rate on LCDS is significantly higher - a significant basis remains between these two derivatives. For firms that issue both loans and bonds, the LCDS market seems to imply higher default probabilities. Accounting for the next difference between the products - that LCDS can cancel without defaulting - does not appear to explain this basis either. Luis proposes a joint model for CDS and LCDS that posits uncertainty in a firm’s initial credit state, and shows that this model can indeed account for much of the basis we observe.

JEL Classification: G10