Thursday, September 6, 2007

Loan-only Credit Default Swaps

An LCDS works very similar to a CDS, with two major differences:

  • The reference obligation on CDS is normally senior unsecured bond. For LCDS, it's secured loan. This means the recovery rate in the event of default is much higher for LCDS than CDS.
  • In the event that the reference obligation is paid down(called), CDS will continue to exist on a different reference obligation but LCDS will cease to exist. This means in addition to the credit risk, LCDS is also exposed to prepayment risk. Hence the pricing model for LCDS should incorporate a interest rate process and a prepament model.

An introducation on LCDS.