Pricing approaches for Credit Derivatives

Author: Theodor Munteanu – Quantitative Risk Analyst and Financial Engineer

Contents
Credit default swaps: .................................................................................................................................... 2
Binary CDS vs. Vanilla CDS ........................................................................................................................ 4
Forward/Deferred CDS.............................................................................................................................. 5
Amortized CDS .......................................................................................................................................... 5
Quanto CDS (dual currency CDS) .............................................................................................................. 6
Diffusion models for intensity of defaults and recovery rates. Which contract is better? Vanilla/binary
CDS? .......................................................................................................................................................... 7
Joint correlated Geometric Brownian motions for default intensity and recovery rates .................... 7
Joint correlated CIR processes for default intensity and recovery rates .............................................. 8
Basket default swaps on credits with equal and unequal expiries ............................................................... 8
Basket default swaps when the components’ expiries are unequal ...................................................... 12
Basket default swaps when default times are not correlated. Calibration of copula parameters......... 12
Diffusion models for basket default swaps............................................................................................. 15
CDX .............................................................................................................................................................. 15
CDX on credits with equal outstanding notionals and expiries .............................................................. 15
CDX on entities with different outstanding notionals and identical expiries ......................................... 17
CDX on entities with different outstanding notional and expiries ......................................................... 18
Diffusion models for CDX ........................................................................................................................ 19
Option pricing approaches for CDOs .......................................................................................................... 19
CDOs with tranches having equal expiries.............................................................................................. 20
CDOs with tranches having different expiries ........................................................................................ 21
Diffusion models for CDOs ...................................................................................................................... 22
CLOs ............................................................................................................................................................ 22
Use credit default swaps and basket default swaps to mitigate credit risk ............................................... 22
An approach to compute RWA when CDS and guarantees are simultaneously used ................................ 23
Credit default swaps:
When it comes to modelling the market risk of credit derivatives, and to study the P&L distribution &
credit risk parameters, one can either touch the spread dynamics or the default intensity dynamics along
with the recovery rate process.

Mathematical framework:
For the protection buyer, assume that we pay 𝑐 on a notional 𝑁, with expiry 𝑇 and frequency 𝑓𝑟𝑒𝑞 of
payments per year. Assume that 𝑡1 , 𝑡2 , … , 𝑡𝑁 are the payment times if the default doesn’t occur until
expiry. Assume also that the instantaneous risk-free rate is 𝑟𝑠 and the recovery rate is 𝑅, which for the
moment is assumed to be fixed. Then the stochastic value of the premium leg and default leg are:
𝑡
𝑆𝑉𝑡 (𝑃𝐿) = ∑𝑡𝑚≥𝑡 𝑐 ⋅ 𝑁 ⋅ (𝑡𝑚 − 𝑡𝑚−1 ) ⋅ 1(𝜏 > 𝑡𝑚 ) ⋅ exp⁡(− ∫𝑡 𝑚 𝑟𝑠 𝑑𝑠)
𝜏
𝑆𝑉𝑡 (𝐷𝐿) = (1 − 𝑅) ⋅ 𝑁 ⋅ 1(𝜏 ≤ 𝑇) ⋅ exp⁡(− ∫𝑡 𝑟𝑠 𝑑𝑠)⁡

The CDS spread is the value of 𝑐 that satisfy 𝐸[𝑆𝑉𝑡 (𝑃𝐿)] = 𝐸[𝑆𝑉𝑡 (𝐷𝐿)] or, the value 𝑐 that makes at
initiation the CDS to be worth 0 to both the buyer and the seller of the protection insurance.

REMARK:

If the interest rates are constant and the default time is 𝐸𝑥𝑝(𝜆) distributed, then we get the credit
triangle relationship: 𝑠(0, 𝑇) = (1 − 𝑅) ⋅ 𝜆
𝜆1 , 0 ≤ 𝑡 ≤ 𝑡1
𝜆 , 𝑡 < 𝑡 ≤ 𝑡2
If we have a piecewise exponential model where 𝜆(𝑡) = { 2 1 then, 𝑠(0, 𝑇) =
…
𝜆𝑛 , 𝑡 ≥ 𝑡𝑛−1
(1 − 𝑅)𝜆1 , 𝑇 ≤ 𝑡1
𝑡1 𝑇−𝑡
(1 − 𝑅) ⋅ (𝜆1 ⋅ + 𝜆2 ⋅ 𝑇 1 ) , 𝑡1 < 𝑇 ≤ 𝑡2
𝑇
…
𝑡1 𝑇−𝑡𝑛−1
{(1 − 𝑅) ⋅ (𝜆1 ⋅ 𝑇 + ⋯ + 𝜆𝑛 ⋅ 𝑇 ) , 𝑇 ≥ 𝑡𝑛−1
Numerical example:

Suppose a bank buys protection on a bullet loan with outstanding notional 𝑁 = 1,000,000$ and expiry
in 5 years issued by a company whose default intensity is 5% per year, and the recovery rate is 50%.

If the risk-free rate is 4.5%, and assuming that the spread follows a geometric Brownian motion with
the diffusion parameter 𝜎 = 20%, we get the main risk results in the tables below (Expected loss,
Expected Shortfall, Risky Present Value of 1 basis point, the spread, the Value at Risk and Economic
Capital based on Expected Shortfall 97.5% and different horizons) when payments are once, twice a
year or quarterly:
Table 1: Risk indicators when 𝒓𝒔 = 𝟎. 𝟎𝟒𝟓, 𝝉 ∼ 𝑬𝒙𝒑𝒐(𝝀 = 𝟓%), 𝑹 = 𝟓𝟎%, 𝑵 =
𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎⁡𝑼𝑺𝑫, 𝝈𝒔𝒑𝒓𝒆𝒂𝒅 = 𝟐𝟎% for different horizons

Feature\Horizon 10 days 20 days 40 days 60 days 120 days

𝐸𝐿 84.1629 197.5656 -15.521 738.64048 -310.667
𝐸𝑆(97.5%) 8,805.088 11,325.65 15,715.11 22,106.253 25,892.26
𝑅𝑃𝑉01 3.835092 3.813261 3.813261 3.8132607 3.813261
𝑠(0,5𝑌) 2.5% 2.5% 2.5% 2.5% 2.5%
𝑉𝑎𝑅(97.5%) 7,280.195 9,659.829 13,776.48 18,443.427 22,522.09
𝐸𝐶𝑎𝑝(97.5%) 8,720.925 11,128.09 15,730.63 21,367.612 26,202.93

If the payments are paid twice a year:

Table 1 bis: Same data as above but for CDS with semi-annual payments of premiums

Feature\Horizon 10 Days 20 Days 40 Days 60 Days 120 Days

𝐸𝐿 -165.617 303.9901 -68.0177 -337.346 344.7659
𝐸𝑆(97.5%) 9,457.356 13,805.61 18,769.44 22,418.19 30,344.84
𝑅𝑃𝑉01 3.847302 3.847302 3.847302 3.847302 3.847302
𝑠(0,5𝑌) 0.028431 0.028431 0.028431 0.028431 0.028431
𝑉𝑎𝑅(97.5%) 7,884.745 11,320.72 16,468.99 19,659.98 26,483.08
𝐸𝐶𝑎𝑝(97.5%) 9,622.973 13,501.62 18,837.45 22,755.53 30,000.07

In case the CDS premiums are paid quarterly:

Table 1c. Quarterly premium payments of CDS

Feature\Horizon 10 Days 20 Days 40 Days 60 Days 120 Days

𝐸𝐿 -58.7312 497.0649 62.98983 -106.934 576.8217
𝐸𝑆(97.5%) 9,564.856 14,454.93 19,764.41 23,111.82 31,973.67
𝑅𝑃𝑉01 3.897162 3.897162 3.897162 3.897162 3.897162
𝑠(0,5𝑌) 0.028067 0.028067 0.028067 0.028067 0.028067
𝑉𝑎𝑅(97.5%) 7,990.289 12,230.91 17,022.53 20,023.49 26,316.98
𝐸𝐶𝑎𝑝(97.5%) 9,623.587 13,957.86 19,701.42 23,218.75 31,396.85

CONCLUSION 1: The CDS with semi-annual payments and quarterly payments display slightly more
credit risk.

Table 2: Risk indicators when 𝒓𝒔 = 𝟎. 𝟎𝟒𝟓, 𝝉 ∼ 𝑾𝒆𝒊𝒃𝒖𝒍𝒍(𝝀 = 𝟓%; 𝜸 = 𝟏. 𝟓), 𝑹 = 𝟓𝟎%, 𝑵 =

𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎⁡𝑼𝑺𝑫, 𝝈𝒔𝒑𝒓𝒆𝒂𝒅 = 𝟐𝟎% for different horizons

Feature\Horizon 10 days 20 days 40 days 60 days 120 days

𝐸𝐿 26.46583 145.8236 24.5478 -257.7438 124.4552
𝐸𝑆(97.5%) 8279.939 12793.22 17183.28 21167.599 30037.03
 𝑅𝑃𝑉01 3.800176 3.800176 3.800176 3.8001764 3.800176
𝑠(0,5𝑌) 2.64% 2.64% 2.64% 2.64% 2.64%
𝑉𝑎𝑅(97.5%) 7,231.175 11,190.11 14,873.09 17,799.887 25,430.3
𝐸𝐶𝑎𝑝(97.5%) 8,253.473 12,647.39 17,158.73 21,425.342 29,912.58

Economic capital is defined in line with the Basel III methodologies where 𝐸𝐶𝑎𝑝 = 𝐸𝑆(97.5%; ℎ) −
𝐸𝐿(ℎ) (depending on the Expected Shortfall instead of VaR (99%).

Table 3: Risk indicators for Exponential model and Piecewise exponential model and horizons of 10 days,
20 days and 40 days. The credit spread volatility is assumed 20%.

Feature\Horizon 10 days 20 days 40 days 10 days 20 days 40 days

𝐸𝐿 -42.0159 80.23297 -456.362 -55.85722 -773.447 48.41065
𝐸𝑆(97.5%) 7925.608 11978.78 14434.16 17597.013 24698.6 35424.01
𝑅𝑃𝑉01 3.813261 3.813261 3.813261 3.3393454 3.339345 3.339345
𝑠(0,5𝑌) 0.025013 0.025013 0.025013 0.0591453 0.059145 0.059145
𝑉𝑎𝑅(97.5%) 6,925.045 10168.6 12511 14383.586 21,525.41 31,165.74
𝐸𝐶𝑎𝑝(97.5%) 7,967.624 11,898.55 14,890.52 17,652.87 25,472.04 35,375.6
Explanation: The first 3 columns represent Exponential Model results (𝜆 = 5%) and the last 3 columns
represent results from a piecewise exponential model with intensity 𝜆(0,1) = 5%, 𝜆(1,2) =
6%, 𝜆(2,3) = 7%, 𝜆(3,4) = 8%, 𝜆(4,5) = 9%, 𝜆(5, +∞) = 11%

Binary CDS vs. Vanilla CDS

Suppose the contract above stipulates that in case of default, 450,000$ would be paid.

We compare in the below table the risks of binary CDS and vanilla CDS.

Table 4: Binary CDS risk measures when assumed recovery rate in case of default is 𝑅 = 50%, the value
paid Is 450,000$ out of 1,000,000 in case of default, annual coupon payment

Feature\Instrument Binary CDS Vanilla CDS

𝐸𝐿 -201.037 -345.457
𝐸𝑆(97.5%) 10,389.65 11,971.07
𝑅𝑃𝑉01 3.600615 3.600615
𝑠(0,5𝑌) 0.032887 0.036541
𝑉𝑎𝑅(97.5%) 8,886.377 9,676.522
𝐸𝐶𝑎𝑝(97.5%) 10,590.69 12,316.52

For more details, there is a special section dedicated on which CDS is riskier.
Forward/Deferred CDS
Suppose now that we want to price a deferred CDS that would start paying premiums in 4 years and end
in 8 years 𝐶𝐷𝑆(0,3,8), that means a forward CDS starting in 3 years, with the first premium paid
annually in 4 years (5 payments).

Table 5: Risk characteristics for Deferred CDS (0,3,8), annual frequency,𝜎𝑠𝑝𝑟𝑒𝑎𝑑 = 𝜎𝑠 = 20%(𝑎𝑛𝑛𝑢𝑎𝑙)

Feature\Instrument Deferred CDS Vanilla CDS

𝐸𝐿 -98.38 -345.46
𝐸𝑆(97.5%; 10𝐷) 15,709.39 11,971.07
𝑅𝑃𝑉01 4.46 3.60
𝑠(0,5𝑌) 0.04 0.04
𝑉𝑎𝑅(97.5%; 10𝐷) 12,593.05 9,676.52
𝐸𝐶𝑎𝑝(97.5%; 10𝐷) 15,807.77 12,316.52

Amortized CDS
Most of the credit instruments have amortizing schemes therefore the CDS instruments that should best
hedge credit risk would be amortized CDS-es.

Amortizable CDS, used in combination with amortized bonds/loans are the ideal and standard hedging
strategies for credit risk.

I will therefore show an example of amortizing CDS:

Numerical example: Suppose a CDS is written so that it corresponds to a loan expiring in 5 years, with
annual amortizements, while the default intensity is estimated at 𝜆 = 600𝑏𝑝𝑠.

The baseline assumption is an exponential model of times to default, and we assume the credit spread
moves at a geometric Brownian motion from the current spread with a 𝐿𝑁(0, 𝜎𝑎𝑛𝑛𝑢𝑎𝑙 = 20%)
distribution.

The economic capital is again based on Expected shortfall – Expected Loss at a level of 97.5%.

Table 6: 𝜎𝑠 = 20%, 5 years, flat term structure 𝑟 = 4.5%:

𝑂𝑢𝑡𝑝𝑢𝑡:⁡EL (expected loss), ES (Expected Shortfall), Risky Present Value of 1 $, spread, Value at Risk and
Economic Capital (horizon = 10 days)

Feature\Instrument Amortized CDS Vanilla CDS

𝑬𝑳 -58.12 -345.46
𝑬𝑺𝟗𝟕.𝟓% 2,284.08 11,971.07
𝑹𝑷𝑽𝟎𝟏 0.53 3.60
𝒔 0.05 0.04
𝑽𝒂𝑹𝟗𝟕.𝟓% 1,963.22 9,676.52
𝑬𝒄. 𝑪𝒂𝒑𝒊𝒕𝒂𝒍(𝑬𝑺; 𝟗𝟕. 𝟓%) 2,342.20 12,316.52
Quanto CDS (dual currency CDS)
Description: The underlying asset is assumed in one currency and the premium and/or the default
payment in another currency.

Context: This instrument is useful when offering insurance on credits issued by entities from low-
developed financial markets, where CDS presence in domestic currency is non-existent or very poor.

If the currency rates and the default times are independent, then a cross-currency CDS (also named
quanto) where both premium and default leg are in foreign currency, display a similar behavior, but with
reference risk-free rate as the local (domestic) rate.

The spread formula for constant default rate (𝜆), and flat term structure rate (𝑟) and the annual
volatility of the FX rate is 𝜎 is given below:
2 +𝜆)(𝑇−𝑡)
(1 − 𝑅)𝜆 1 − 𝑒 −(𝑟𝑑𝑜𝑚−𝜎 1
𝑠= ⋅ ⋅ 2
𝑟𝑑𝑜𝑚 − 𝜎 2 + 𝜆 𝑇−𝑡 ∑𝑡𝑚≥𝑡 Δ𝑡𝑚 𝑒 −(𝑡𝑚−𝑡)(𝑟𝑑𝑜𝑚+𝜆−𝜎 ) ⁡

For more details about this formula, you can contact me via Linkedin.
𝟐)
The new risky present value of a unit dollar is ∑𝒕𝒎 ≥𝒕 𝚫𝒕𝒎 𝒆−(𝒕𝒎 −𝒕)(𝒓𝒅𝒐𝒎 +𝝀−𝝈 = 𝑹𝑷𝑽𝟎𝟏

Numerical example & context:

A borrower from Romania issues a loan of 10,000,000 RON towards a Romanian investment bank. The
bank, in order to cover against credit risk, wants to buy insurance, but cannot buy CDS on the local
market but only on the international market.

He accepts to enter a CDS where default and premium leg are paid in euros in case of default, at the
initial historical exchange rate. Suppose that the initial FX rate is 𝑋0 = 5𝑅𝑂𝑁/𝐸𝑈𝑅𝑂 and the EURO and
ROMANIAN LEU risk-free interest rates are at 4.1% (EURIBOR 6M) and 6.1% levels (ROBOR 6M).

Then for a 5-year CDS, corresponding to the 5-year loan, without amortizement, and where annual
payments for the insurance are made, we get the results below:

Table 7: Risk Characteristics when recovery R = 40%, 𝜆 = 4.5%, 𝑟𝑅𝑂𝑁 = 6.1%, 𝑟𝐸𝑈𝑅 = 4.1%

The horizon used Is 10 days.

Feature\Instrument Vanilla 𝑪𝑫𝑺 Quanto 𝑪𝑫𝑺

𝑬𝑳 100.8305 -72.13
𝑬𝑺(𝟗𝟕. 𝟓%) 11,214.81 10,640.24
𝑹𝑷𝑽𝟎𝟏 3.787047 5.10
𝒔(𝟎, 𝟓) 3.20% 2.45%
𝑽𝒂𝑹(𝟗𝟕. 𝟓%; 𝟏𝟎𝑫) 9,638.133 9,101.73
𝑬𝑪, 𝑪𝒂𝒑(𝟗𝟕. 𝟓%; 𝟏𝟎𝑫) 11,113.98 10,712.86
Diffusion models for intensity of defaults and recovery rates. Which contract is better?
Vanilla/binary CDS?
Joint correlated Geometric Brownian motions for default intensity and recovery rates

Context & Numerical example: Assume that we wonder ourselves whether to use a vanilla CDS or
binary CDS to hedge the credit risk, but we would also like to benefit from the potential gains.

For that we have the choice between entering a 5-year vanilla CDS and entering a binary CDS that pays
500,000 $ on an outstanding notional of 1,000,000 $.

The risk-free rate is 4.5%, the payments of CDS are made on an annual basis.

We consider that both the recovery and default intensity present uncertainty in the future.

Hence one may use the stochastic process for each credit risk parameter:

𝑑𝜆𝑡 = 𝜎1 𝑅𝑡 𝑑𝐵𝑡1

𝑑𝑅𝑡 = 𝜎2 𝑅𝑡 𝑑𝐵𝑡2

where 𝜌(𝐵𝑡1 , 𝐵𝑡2 ), 𝜎1 , 𝜎2 are given.

Below I present the results for Value at Risk 95% for 1 month horizon when several hypothetical
situations occur:

Table 8: The intensity and recovery are correlated GBMs

𝑉𝑎𝑅95% (1𝑀) Vanilla CDS Binary CDS

𝜎1 = 𝜎2 = 20%, 𝜌 = 50% 145,713.65$ 111,173.33$
𝜎1 = 𝜎2 = 20%, 𝜌 = −50% 170,731.32$ 108,071.43$
𝜎1 = 𝜎𝜆 = 20%,𝜎2 = 0% 111,175$ 108,071.33$
𝜎2 = 𝜎𝑅 = 20%,𝜎1 = 0% 149,448$ -5,416.0958

One may see that when both recovery rate and default intensity are uncertain, the binary CDS is a more
secure instrument than the vanilla CDS to be held.

Most of the risk is born by the default intensity risk, however as one can see from cases III and IV.

In case of geometric Brownian motions, there are no closed formulas for the survival probabilities, but
one can use the associated PDE of the survival function 𝑆(𝑡, 𝑇) and then solve it numerically.

THEOREM (PDE of survival function when 𝝀𝒔 is a geometric Brownian motion):

If 𝜆(𝑡): 0 ≤ 𝑡 ≤ 𝑇 satisfies the stochastic equation 𝑑𝜆𝑡 = 𝑎(𝜆(𝑡))𝑑𝑡 + 𝑏(𝜆(𝑡))𝑑𝐵𝑡 then the function
𝑆(𝑡, 𝑇) satisfies the following parabolic equation:
𝜕2 𝑆 1 2 𝜕𝑆 𝜕𝑆
𝜕𝜆2𝑡
⋅ 2 𝑏(𝜆(𝑡)) + 𝑎(𝜆(𝑡)) ⋅ 𝜕𝜆 − 𝜕𝑡 − 𝜆(𝑡)𝑆(𝑡, 𝑇, 𝜆(𝑡)) = 0

Proof:
 𝑇 𝑇
𝑆(𝜆𝑡 , 𝑡, 𝑇) = 𝐸𝑄 [𝑒 − ∫𝑡 𝜆𝑠 𝑑𝑠
|𝐹𝑡 ] = 𝐸𝑄 [𝑒 − ∫𝑡 𝜆𝑠 𝑑𝑠
|𝜆𝑡 ] because 𝜆𝑡 follows a Markov process.

(here 𝐹𝑡 = 𝜎(𝜆𝑠 |0 ≤ 𝑠 ≤ 𝑇))

𝑡
Call 𝑣(𝑡, 𝑥) = 𝑆(𝑥, 𝑇 − 𝑡, 𝑇) = 𝐸𝑄 [𝑒 − ∫0 𝜆(𝑠+𝑇−𝑡)𝑑𝑠⁡ |𝜆(𝑇 − 𝑡) = 𝑥]
𝜕𝑣 𝜕𝑣 1 𝜕2 𝑣
By Feynman Kac formula, 𝜕𝑡 (𝑡, 𝑥) = 𝑎(𝑥) 𝜕𝑥 (𝑡, 𝑥) + 2 𝑏(𝑥)2 𝜕𝑥 2 − 𝑥𝑣(𝑡, 𝑥)

𝜕𝑆(𝜆𝑡 ,𝑡,𝑇) 𝜕𝑣(𝑇−𝑡,𝜆(𝑡))

But 𝜕𝑡
=− 𝜕𝑡
hence our conclusion.

Joint correlated CIR processes for default intensity and recovery rates
Assume that the default intensity (𝜆𝑡 ) and recovery rate (𝑅𝑡 ) are following the processes:

𝑑𝜆𝑡 = 𝑘1 (𝜃1 − 𝜆𝑡 )𝑑𝑡 + 𝜎1 √𝜆𝑡 𝑑𝑊𝑡1

𝑑𝑅𝑡 = 𝑘2 (𝜃2 − 𝑅𝑡 )𝑑𝑡 + 𝜎2 √𝑅𝑡 𝑑𝑊𝑡2

Where 𝑘1 = 𝑘2 = 0.95, 𝜃1 = 5%, 𝜃2 = 50%

Assume that we want to price 5-year CDS after 1 month, given the initial spreads of each. The worst 5%
PnLs in either case are presented below under 4 possible scenarios:

𝑉𝑎𝑅95% (1𝑀) Vanilla CDS Binary CDS

𝜎1 = 𝜎2 = 20%, 𝜌 = 50% 50,539.15$ 42,590.29$
𝜎1 = 𝜎2 = 20%, 𝜌 = −50% 51,932.17$ 43,235.21$
𝜎1 = 𝜎𝜆 = 20%,𝜎2 = 0% 42,590.29$ 42,590.29$
𝜎2 = 𝜎𝑅 = 20%,𝜎1 = 0% 45,354.99$ 6,758.46$

The binary CDS is more secure than vanilla CDS when joint default and recovery risk are considered.

Remark: The affine diffusion processes are preferred to geometric Brownian motion, because the first
model can be calibrated from empirical survival probabilities, unlike the latter model.

Basket default swaps on credits with equal and unequal expiries

Mathematical framework

Suppose we wish to value a 𝑘-to-default swap on 𝑛 credits written by 𝑛 entities whose notionals are
𝑁1 , 𝑁2 , … , 𝑁𝑛 , the recovery rates are 𝑅1 , 𝑅2 , … , 𝑅𝑖 = (1 − 𝐿𝐺𝐷)𝑖 , and the default times are 𝜏𝑖

The stochastic value of the premium leg and default leg can be represented as follows:
𝑡
𝑆𝑉𝑡 (𝑃𝐿) = 𝑐 ⋅ 𝑁 ⋅ ∑𝑡𝑚≥𝑡 Δ𝑡𝑚 ⋅ 1{𝜏𝑘:𝑛 ≥ 𝑡𝑚 } ⋅ exp⁡(− ∫𝑡 𝑚 𝑟𝑠 𝑑𝑠)⁡ and
𝜏
𝑆𝑉𝑡 (𝐷𝐿) = 𝑋 ⋅ 1{𝜏𝑘:𝑛 ≤ 𝑇} ⋅ 𝑒𝑥𝑝(− ∫𝑡 1:𝑛 𝑟𝑠 𝑑𝑠)⁡⁡ where 𝜏𝑘:𝑛⁡ is the 𝑘 𝑡ℎ default time between the 𝑛
entities where 𝑋 = ∑𝑛𝑖=1 1{𝜏𝑘:𝑛 = 𝜏𝑖 }(1 − 𝑅𝑖 )𝑁𝑖
 𝐸[𝑋⋅1(𝜏𝑘:𝑛 ≤𝑇)𝐵𝑡 (𝜏𝑘:𝑛 )]
The value of the spread 𝑘𝑇𝐷 is 𝑠 𝑘𝑇𝐷 = 𝑁⋅∑ where 𝑁 is the notional defined in the
𝑡𝑚 ≥𝑡 Δ𝑡𝑚 𝑆𝑘:𝑛 (𝑡𝑚 )⋅𝐵𝑡 (𝑡𝑚 )
k-to-default contract.

REMARKS:

1. If 𝑘 = 1, 𝜏𝑖 ∼ 𝐸𝑥𝑝𝑜𝑛𝑒𝑛𝑡𝑖𝑎𝑙(𝜆𝑖 ) ⇒ 𝜏1:𝑛 = min(τ1 , … , 𝜏𝑛 ) ∼ 𝐸𝑥𝑝𝑜𝑛𝑒𝑛𝑡𝑖𝑎𝑙(𝜆1 + ⋯ + 𝜆𝑛 )

𝝀𝒊
2. 𝑷(min(𝝉𝟏 , … , 𝝉𝒏 ) = 𝝉𝒊 ) = 𝝀 +⋯+𝝀
𝟏 𝒏

𝑹𝑷𝑽𝟎𝟏 = ∑𝑡𝑚≥𝑡 Δ𝑡𝑚 𝑆𝑘:𝑛 (𝑡𝑚 ) ⋅ 𝐵𝑡 (𝑡𝑚 )

Example 1:

Suppose we wish to issue a First to default credit swap defined on three entities that have issued 3
bonds expiring in 5 years, that pay annual coupons of 7%, 9% and 11%. The recovery rates are 50%,60%
and 40% respectively and the default intensities of 6%, 8% and 11%

The face values of the bonds are 1,000,000$ each. The spreads and RPV’s for a First-to-default swap
with contractual notional of 𝑁 = 1,000,000$⁡and yearly payments are in the table below:

Entity Spread 𝑅𝑃𝑉01

First to-default swap 14.16% 2.33
Second to default swap 3.08% 3.94
Third to default swap 0.33% 4.45

If the default intensities and credit spreads go up-and-down with 50bps, 100 bps and 200 bps we have
the following spread:

Spread (𝒔) 𝝀 𝝀 + 𝟏% 𝝀 − 𝟏% 𝝀 + 𝟎. 𝟓%⁡ 𝝀 − 𝟎. 𝟓%

𝑭𝒕𝑫 14.97% 17.05% 13.09% 16.06% 14.09%
𝑺𝒕𝑫 3.11% 3.72% 2.44% 3.41% 2.80%
𝑻𝒕𝒅 0.37% 0.48% 0.29% 0.41% 0.35%

The first-to-default swap is 2 times riskier than the second to default swap and 10 times riskier than a 3rd
to default swap.

The Value at Risk 99% for 10-day, 20-day, 40-day, 60-day and 120-day horizon of such an instrument
need a spread dynamic assumption.

Assume the ratings of the three entities are BB, B and C where a universe of 6 ratings are AA, A, BB, B, C
and D (default)

The transition matrix is assumed to be 𝑃(1) = (𝑝𝑖𝑗 ) and the last row is 𝑃(1)(6, . ) = (0,0,0,0,0,1)
1≤𝑖,𝑗≤6

The Value at Risk is found by assuming a P&L distribution. The fastest way to compute the 𝑃&𝐿 is to
use⁡𝑅𝑃𝑉01 approach, or a 𝑅𝑃𝑉 − 𝜃 approach if the horizon is greater than 20 days.

Therefore one needs to assume a CDS spread dynamics and volatility:

 𝑑𝑠𝑖 (𝑡) = 𝜎𝑖 𝑠𝑖 (𝑡)𝑑𝐵𝑡
The Value at Risk, Expected shortfall and Expected Loss for 10 days, 20 days, 40 days, 60 days and 120
days horizons are given in the table below:

Horizon (𝒉)⁡ 𝑽𝒂𝑹(𝟗𝟗%, 𝒉) 𝑽𝒂𝑹(𝟗𝟕. 𝟓%, 𝒉) 𝑬𝑺(𝟗𝟕. 𝟓%; 𝒉) 𝑬𝑳(𝒉𝒐𝒓) 𝑬𝑪𝒂𝒑(𝟗𝟕. 𝟓%𝑬𝑺) ECap(99%VaR)
10D 28,934.07 25,199.06 28,760.71 -837.283 29,598 29,771.3
20D 43,159.29 35,957.8 44,281.55 890.6858 43,390.9 42,268.6
40D 54,243.96 44,957.42 55,136.68 1,085.477 54,051.2 53,158.5
60D 65,630.83 56,471.7 67,128.81 796.0629 66,332.7 64,834.8
120D 90,834.41 75,015.39 89,480.94 -1,448.89 90,929.8 92,283.3

The economic capital based on 97.5% Expected shortfall for the Basket Default Swaps are increasing for
the horizons mentioned.

Example 2:

Suppose we have two credits, represented by bullet loans with outstanding notionals 𝑁1 , 𝑁2 ,expiries
equal to 𝑇1 = 5⁡years, 𝑇2 = 8⁡years and we wish to price a First-to-default swap issued on these two
loans.

This instrument can be decomposed into a First-to-Default Swap that would expire in 5 years + a
forward(deferred) CDS that will start payments in 5 years and would end its payments at time 𝑇2

𝑆𝑉𝑡 (𝐷𝐿) = 𝑋 ⋅ 1(𝜏1:2 ≤ 𝑇1 )𝐵(𝑡, 𝜏1:2 ) + 𝑁2 ⋅ 1(𝜏2 ≥ 𝑇1 ) ⋅ 1(𝜏2 ≤ 𝑇2 )

REMARK: If the default times are independent then the expected value of the default leg is the default
leg for a 𝑻𝟏 -year FtD swap + the default leg of a CDS that starts payments in 𝑻𝟏 + 𝟏 years and ends in
𝑻𝟐 years × 𝑷(𝝉𝟏 > 𝑻𝟏 )

The stochastic value of the premium leg is 𝑆𝑉𝑡 (𝑃𝐿) = Premium leg of a first-to-default swap
(0, 𝑇1 , 𝑁1 , 𝑁2 ) + premium leg of a deferred CDS which pays after 𝑇1 years and ends in 𝑇2 years

The premium leg of 𝐹𝑜𝑟𝑤𝑎𝑟𝑑(𝐶𝐷𝑆; 𝑇1 , 𝑇2 ) = 𝑃𝐿(𝐶𝐷𝑆(𝑇2 )) − 𝑃𝐿(𝐶𝐷𝑆(𝑇1 ))

Numerical examples:

1. Suppose the default intensities are 5% for the first entity, 8% for the second entity, the entities
issue 𝑁 =1,000,000 euro bullet loans and the recovery rates are 50% each. The loans expire in 5
years and 8 years respectively.

What is the value of a derivative that covers against the first default on a period of 8 years based on
the 2 loans if a premium of 12% out of the notional 𝑵 = 𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎$ is required to be paid yearly?

The product can be structured as a First-to-default swap for 5 years + forward swap between 5 year
and 8-year expiry.

The characteristics of the First to default, Second to default swap are covered in the table below:

Product 𝑆𝑝𝑟𝑒𝑎𝑑 𝑅𝑃𝑉01 𝑉𝑎𝑅99% (10𝐷) 𝑉𝑎𝑅97.5%(10𝐷) 𝐸𝑆97.5% (10𝐷) 𝐸𝐿 𝐸𝑐𝑎𝑝

 𝐹𝑇𝐷 7.45% 3.64 25985.8495 21,725.6345 24,820.8954 -91.77 25,190.61
𝑆𝑇𝐷 0.8% 6.09 5416.31 4,656.51 5,514.34577 12.28 5,502.06

The Economic capital is based on the 𝐸𝑆(97.5%; 10𝐷) and the expected loss for 10 days horizon.

2. Suppose the default intensities are 5%, 8% and 11%, the entities issue 𝑵 = 𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 euro
bullet loans and the recoveries are 40%, 60%, 70%. The loans expire in 5 years, 8 years and 10
years.
For 10 days horizon we have the results shown below:

Feature\Product 𝐹𝑡𝐷 𝑆𝑡𝐷 𝑇𝑡𝐷

𝐸𝐿(ℎ𝑜𝑟 = 10𝐷) -435.726 263.8852 48.13225
𝐸𝑆(97.5%, 10𝐷) 28182.84 13390.05 2421.933
𝑅𝑃𝑉01 2.74122 5.699386 7.418773
𝑠(0; 5𝑌, 8𝑌, 10𝑌) 10.71% 2.57% 0.38%
𝑉𝑎𝑅(97.5%; 10𝐷) 23191.63 11454.95 2143.801
𝐸𝐶𝑎𝑝(97.5%; 10𝐷) 28618.57 13126.17 2373.801

For a horizon of 20-days we have the following results:

Feature\Product FtD StD TtD

𝐸𝐿(ℎ𝑜𝑟 = 20𝐷) -280.089 -420.036 55.86692
𝐸𝑆(97.5%, 20𝐷) 26,554.43 13,119.53 2,559.683
𝑅𝑃𝑉01 2.74122 5.699386 7.418773
𝑠(0; 5𝑌, 8𝑌, 10𝑌) 0.107148 0.025732 0.003812
𝑉𝑎𝑅(97.5%; 20𝐷) 21,596.81 10,775.85 2,305.203
𝐸𝐶𝑎𝑝(97.5%; 20𝐷) 26,834.52 13,539.57 2,503.816

The required capital (Economic Capital based on the Expected Shortfall 97.5%) is decreasing with the
entity that defaults, and corresponds to a junior, mezzanine and senior tranche.

Example 3:

Let us assume a portfolio contains 𝑛1 ⁡credits with notionals 𝑁1 , 𝑁2 , … , 𝑁𝑛1 and expiry (𝑇1 ) and 𝑛2 credits
with notionals 𝑁𝑛1 +1 , … , 𝑁𝑛1 +𝑛2 (expiry = 𝑇2 )

Suppose the premium is paid based on a notional 𝑁, not necessarly equal to any of the notionals 𝑁𝑖 , 𝑖 ∈
{1,2, … , 𝑛1 + 𝑛2 }
𝑡 <𝑇
The stochastic value of the premium leg is: 𝑆𝑉𝑡 (𝑃𝐿) = 𝑐 ⋅ 𝑁 ⋅ ∑𝑡𝑚
𝑚 ≥𝑡
1
1{𝜏1:𝑛1 +𝑛2 > 𝑡𝑚 }𝐵(𝑡, 𝑡𝑚 ) + 𝑐 ⋅ 𝑁 ⋅
∑𝑡𝑡𝑚 ≤𝑇2
𝑚 >𝑇1
1(𝜏𝑛1 +1:𝑛1 +𝑛2 > 𝑡𝑚 )𝐵(𝑡, 𝑡𝑚 ) = 𝑃𝐿(𝐹𝑡𝐷(𝐸1 , 𝐸2 , … , 𝐸𝑛1 +𝑛2 ; 𝑇1 ))⁡] + 𝑃𝐿(𝐹𝑡𝐷(𝑛1 + 1, … , 𝑛1 +
𝑛2 ; 𝑑𝑒𝑓𝑒𝑟𝑟𝑒𝑑, 𝑇1 , 𝑇2 ))
The stochastic value of the default leg is: 𝑆𝑉𝑡 (𝐷𝐿) = 𝑋1 ⋅ 1{𝜏1:𝑛1 +𝑛2 ≤ 𝑇1 }𝐵(𝑡, 𝜏1:𝑛1 +𝑛2 ) + 𝑋2 ⋅
𝑛 +𝑛
1{𝑇1 ≤ 𝜏1:𝑛1 , 𝜏𝑛1 +1:𝑛2 ∈ (𝑇1 , 𝑇2 )}𝐵(𝑡, 𝜏𝑛1 +1:𝑛1 +𝑛2 ) where 𝑋1 = ∑1 1 2 1{𝜏1:𝑛1 +𝑛2 = 𝜏𝑖 }(1 − 𝑅𝑖 )𝑁𝑖 =
(1 − 𝑅𝑖∗ )𝑁𝑖∗ and 𝑋2 = ∑𝑛𝑛11 +𝑛 2
+1 1{𝜏𝑛1 +1:𝑛1 +𝑛2 = 𝜏𝑖 }(1 − 𝑅𝑖 )𝑁𝑖

In case the two classes of entities show independent default times, then the value of the premium leg
and default leg are the value of a first-to-default swap on 𝑛1 + 𝑛2 ⁡credits and expiry 𝑇1 + a deferred first
to default swap starting the payments in 𝑇1 and ending in 𝑇2 on 𝑛2 entities.

Basket default swaps when the components’ expiries are unequal

Mathematical approach

In this case, only the stochastic value of the default leg changes as follows:
𝑛 𝜏1:𝑛
𝑆𝑉𝑡 (𝐷𝐿) = ∑(1 − 𝑅𝑖 )𝑁𝑖 ⋅ 1{𝜏1:𝑛 = 𝜏𝑖 } ⋅ 1{𝜏𝑖 ≤ 𝑇𝑖 }exp⁡(− ∫ 𝑟𝑠 𝑑𝑠)⁡
𝑖=1 𝑡

Here 𝑇𝑖 are the expiries of the underlying entities (loans/bonds).

Numerical example 4:

If we assume a first-to-default swap with independent default times expo distributed with intensities
6%, 8%. 11%, recovery rates of 50%, 60%, 40%, expiries of 5 years, 7 years and 9 years and annual
payments we obtain the following results:

Feature\Product 𝑭𝒕𝑫 𝑺𝒕𝑫 𝑻𝒕𝑫

𝐸𝐿(20𝐷) -948.425 99.29127 93.95001
𝐸𝑆(97.5%, 20𝐷) 34,746.63 16,728 3,545.213
𝑅𝑃𝑉01 2.598262 5.316148 6.835382
𝑠(0; 5𝑌, 7𝑌, 9𝑌) 15.0% 3.4% 0.6%
𝑉𝑎𝑅(97.5%; 20𝐷) 29,013.35 14,072.93 3,015.236

The risk-free rate curve is assumed flat at 4.5% and the face value of the contract is equal to the face
values of each entity: 1,000,000 euros.

Actually, the spreads are independent of the outstanding notional debts, if these are equal along with
their recovery rates.

Basket default swaps when default times are not correlated. Calibration of copula
parameters
Numerical example (Compare independent, Clayton, normal and student copulas):
Suppose we want to price a first-to-default swap on 3 entities, representing credits issued by 3 SMEs,
with outstanding notionals equal to 1,000,000$⁡each, the default times being exponentially distributed
with parameters 6%, 8% and 11%.

The loss given defaults for the 3 SMEs are 50%,40% and 60% respectively.
The contract will expire in 5 years and the risk-free rates are considered to be all around 3.5%

Feature\Model Indep. Exp (𝝀𝒊 )⁡ 𝑪𝒍𝒂𝒚𝒕𝒐𝒏(𝜽) 𝑵𝒐𝒓𝒎𝒂𝒍(𝝆) 𝑻𝝂

𝐸𝐿(10𝐷) -92.26 -347.80 165.27 -533.59
𝐸𝑆(97.5%, 10𝐷) 29698.31 20536.83 22912.45 23,895.21
𝑅𝑃𝑉01 2.31 2.97 2.66 2.71
𝑠(0; 5𝑌, 5𝑌, 5𝑌) 0.14 0.08 0.10 0.10
𝑉𝑎𝑅(97.5%; 10𝐷) 25564.48 16390.39 19429.93 19,538.66
𝑬𝑪𝒂𝒑(𝟗𝟕. 𝟓%; 𝟏𝟎𝑫) 29790.57 20884.63 22747.18 24,428.79

1 0.5 0.3
Here 𝜃 = 1.5, 𝜌 = [0.5 1 0.4],𝜈 = 5
0.3 0.4 1

Below there is the graph for spreads in case of each BDS.

Figure 1: Spreads of basket default swaps when multivariate Clayton copula are used

In case of normal copulas with 𝜌 correlation matrix we have the following plot:

Figure 2: Spread of a Basket Default Swap when defaults are exponential with normal copula
Here we consider the default times exponentially distributed but with the correlations between the first
and second entity increasing from 0 to 70%.

We observe that a single correlation in case of normal copula doesn’t affect significantly the spread
(whether it is the first, second or third-to-default spread).

Methodology of copula simulation for Clayton case:

1
−
𝜃
The Clayton copula, given by 𝑪(𝒖𝟏 , … , 𝒖𝒏 ) = (𝑢1−𝜃 + 𝑢2−𝜃 + ⋯ 𝑢𝑛−𝜃 − (𝑛 − 1)) is a frailty copula and
can be represented by 𝐶(𝑢1 , 𝑢2 , … , 𝑢𝑛 ) = Ψ(Ψ −1 (𝑢1 ) + Ψ −1 (𝑢2 ) + ⋯ + Ψ −1 (𝑢𝑛 ))⁡where Ψ(𝑥) =
1
Laplace transform of a random variate 𝑥 issued from Γ(𝜃 , 1) distribution
1
In this case, Ψ(𝑥) = (1 + 𝑥)−𝜃 . Hence we obtain the following algorithm:

1. We simulate 𝑣1 , 𝑣2 , … , 𝑣𝑛 as 𝑛 independent uniform variates

1
2. Simulate the frailty random variate 𝑥, namely from Γ(𝜃 , 1) distribution
1 1 1
ln(𝑣1 ) −𝜃 ln(𝑣2 ) −𝜃 ln(𝑣𝑛 ) −𝜃
3. (𝒖𝟏 , 𝑢2 , … , 𝑢𝑛 ) ← ((1 − 𝑥
) , (1 − 𝑥
) , … , (1 − 𝑛
) )

Kendall’s tau:

Genest and McKay show that for an Archimedean copula, the expression of Kendall’s tau is:
1 𝜙(𝑢)
𝜏 < 𝐶 >= 1 + 4 ∫0 𝜙′ (𝑢)
𝑑𝑢⁡where 𝜙⁡is the generator of an Archimedean copula satisfying:

𝜙(1) = 0, 𝜙 ′ (𝑢) < 0, 𝜙 ′′ (𝑢) > 0, ∀𝑢 ∈ [0,1]

The Clayton copula can be written as 𝐶(𝑢1 , 𝑢2 ) = 𝜙 −1 (𝜙(𝑢1 ) + 𝜙(𝑢2 )), 𝜙(𝑢) = 𝑢−𝜃 − 1⁡
𝜃
Therefore 𝜏 = 𝜃+2⁡ so if we apply the method of moments then we can find the parameter 𝜃 such that
the theoretical 𝜏 is equal to the empirical 𝜏

Diffusion models for basket default swaps

𝑗
Suppose the intensities of the defaults for entities 𝑖 are: 𝑑𝜆𝑖 (𝑡) = 𝜎𝑖 𝜆𝑖 (𝑡)𝑑𝐵𝑡𝑖 where 𝑑𝐵𝑡𝑖 𝑑𝐵𝑡 = 𝜌𝑖𝑗

One conclusion I have reached is that the higher the correlation between the default intensities is, the
narrower gets the difference between spreads.

Numerical example:

Suppose we have in a portfolio 3 basket default swaps:

• A first to default swap on 3 loans

• A second to default swap on the same 3 loans
• A third to default swap on the same 3 loans

As above, the notional outstandings are 1,000,000 euros each, the recovery rates are 50%,60%,40% and
the initial default rates are 6%,8%,11%

The volatilities of the default intensities are 𝜎1 = 𝜎2 = 𝜎3 = 20%, while the correlation between the
default intensities are 𝜌12 = 𝜌23 = 𝜌13 = 50%

Then we have the following results regarding the Value at Risk 95% for a 1 month horizon:

Basket default swap 𝑉𝑎𝑅(95%; 1𝑀)

First to Default Swap 30,821.46667$
Second to Default Swap 16,719.1852$
Third to Default Swap 3,529.1106$

CDX
CDX on credits with equal outstanding notionals and expiries
In this case consider 𝑁1 = 𝑁2 = ⋯ = 𝑁𝑛 the outstanding notionals of 𝑛⁡credits from 𝑛 different entities.

An insurance buyer would pay a rate 𝑐 on the notional 𝑁 = (𝑁1 + 𝑁2 + ⋯ + 𝑁𝑛 ). Every time a default
happens, the notional would decrease by 𝑁/𝑛
1
The outstanding notional can therefore be written as 𝑁𝑡 (𝑢) = 𝑁 ⋅ (1 − 𝑛 ∑𝑛𝑖=1 1(𝜏𝑖 ≤ 𝑢))

𝑘
After the 𝑘 𝑡ℎ default, the notional would become 𝑁 (1 − 𝑛)
1
At time 𝑢 ≥ 𝑡, the cumulative loss would be 𝐿𝑡 (𝑢) = 𝑛 ∑𝑛𝑖=1 𝑁(1 − 𝑅𝑖 )1(𝜏𝑖 ≤ 𝑢) meaning that the
incremental loss between two fixing times is Δ𝐿𝑡 (𝑡𝑚 ) = 𝐿𝑡 (𝑡𝑚 ) − 𝐿𝑡 (𝑡𝑚−1 )
One may deduce that the stochastic value of the premium and default legs are:
𝑡
𝑆𝑉𝑡 (𝑃𝐿) = 𝑐∑Δ𝑡𝑚 𝑁𝑡 (𝑡𝑚 )𝐵(𝑡, 𝑡𝑚 ) where 𝐵𝑡 (𝑡𝑚 ) = exp⁡(− ∫𝑡 𝑚 𝑟𝑠 𝑑𝑠)
𝑡
𝑆𝑉𝑡 (𝐷𝐿) = ∑Δ𝐿𝑡 (𝑡𝑚 )exp⁡(− ∫𝑡 𝑚 𝑟𝑠 𝑑𝑠)⁡
𝑡
E[Δ𝐿𝑡 (𝑡𝑚 )exp ∑(− ∫𝑡 𝑚 𝑟𝑠 𝑑𝑠)]
Therefore 𝑐 = 𝐸[∑Δ𝑡𝑚 𝑁𝑡 (𝑡𝑚 )𝐵(𝑡,𝑡𝑚 )]

REMARK:

In the particular case where 𝜏𝑖 ∼ Exponential(𝜆𝑖 ) and the risk-free is approximated with an average 𝑟𝑓
interest rate risk-free, then:
𝑛 𝑛
1 1
𝐸[Lt (𝑢)] = ∑ 𝑁(1 − 𝑅𝑖 )(1 − 𝑒 −𝜆𝑖𝑢 ) ⇒ 𝐸[Δ𝐿𝑡 (𝑡𝑚 )] = ⋅ 𝑁 ⋅ ∑(1 − 𝑅𝑖 )(𝑒 −𝜆𝑖𝑡𝑚−1 − 𝑒 −𝜆𝑖𝑡𝑚 )
𝑛 𝑛
1 1

1 𝑁 𝑛 −𝜆 𝑢
On the other hand the notional outstanding is 𝐸[𝑁𝑡 (𝑢)] = 𝑁 (1 − 𝑛 ∑𝑃(𝜏𝑖 ≤ 𝑢)) = ∑ 𝑒 𝑖
𝑛 1

Therefore the CDX spread can be reduced at:

[𝑇⋅𝑓𝑟𝑒𝑞]
𝑠 𝐶𝐷𝑋 = 𝑇
⋅ ∑𝑡𝑚≥𝑡 ∑𝑛1(1 − 𝑅𝑖 ) (𝑒 −𝜆𝑖𝑡𝑚−1 − 𝑒 −𝜆𝑖𝑡𝑚 )𝑒 −𝑟(𝑡𝑚−𝑡) /(∑𝑡𝑚≥𝑡 ∑𝑛1 𝑒 −(𝜆𝑖+𝑟)(𝑡𝑚−𝑡) )⁡⁡where
𝑓𝑟𝑒𝑞 = the frequency of payments of the coupon (the spread) of the CDS (containted in the premium
leg)

REMARK 2:
𝑁 𝑁
If the notionals and recoveries are equal, 𝑁1 = 𝑁2 = ⋯ = 𝑁𝑛 = ⇒ 𝑠 𝐶𝐷𝑋 ⋅ 𝑁 = ∑𝑛1 𝑠𝑖𝐶𝐷𝑆 ⋅
𝑛 𝑛

If the notionals are not equal, but the recoveries are, then 𝑠 𝐶𝐷𝑋 = 𝑤1 𝑠1𝐶𝐷𝑆 + ⋯ + 𝑤𝑛 𝑠𝑛𝐶𝐷𝑆

Numerical example:

Suppose an investor buys a CDX on 3 entities with recovery rates 50%, 50%, 50%, default intensities 6%,
8% and 11%. The notionals of the underlying credits are 1,000,000 EUROS each and the contract
notional is also 1,000,000⁡EUROS.

Assume the frequency of payments on the CDX is once a year.

The results for the independent exponential default times are below:

Feature\Horizon 10 days 20 days 40 days 60 days 120 days

𝐸𝐿 332.6157 68.27689 145.6076 -255.392 36.92013
𝐸𝑆(97.5%) 14,600.23 20,015.13 30,343.76 33,794.02 46,589.28
𝑅𝑃𝑉01 3.75 3.75 3.75 3.75 3.75
𝑠(0; 5𝑌, 5𝑌, 5𝑌) 0.043 0.043 0.043 0.043 0.043
𝑉𝑎𝑅(97.5%) 13,002.86 17,416.27 25,204.45 29,009.8 41,041.69
𝐸𝐶𝑎𝑝(97.5%) 14,267.62 19,946.86 30,198.15 34,049.41 46,552.36
CDX on entities with different outstanding notionals and identical expiries
In this case the notional outstanding can be written as:

𝑁𝑡 (𝑢) = ∑𝑛𝑖=1 𝑁𝑖 ⋅ (1 − (𝜏𝑖 ≤ 𝑢)) and the loss 𝐿𝑡 (𝑢) = ∑𝑛1 𝑁𝑖 (1 − 𝑅𝑖 )1(𝜏𝑖 ≤ 𝑢)

If the outstanding notionals are not equal, the recoveries are not equal but the expiries are, then the
following result holds:
𝑁1 𝑁𝑛
𝑠 𝐶𝐷𝑋 = 𝑠1𝐶𝐷𝑆 ⋅ (1 − 𝑅1 ) ⋅ + ⋯ 𝑠𝑛𝐶𝐷𝑆 (1 − 𝑅𝑛 ) ⋅
∑(1 − 𝑅𝑖 )𝑁𝑖 ∑(1 − 𝑅𝑖 )𝑁𝑖
Suppose we have a triple-name CDX on 3 loans with notionals outstanding 𝑁1 , 𝑁2 , 𝑁3 =
300,000; 200,000; 100,000$ each, recovery rates 𝑅1 = 60%, 𝑅2 = 50%, 𝑅3 = 40%, and default
intensities 5%, 8%, 10%. The loans have all 5 years to expiry.

If the default times are independent, the spread of a CDX with 5 year expiry is 𝑠 𝐶𝐷𝑋 ≈ 3.4%

The results for independent exponential defaults are below:

Feature\Horizon 10D 20D 40D 60D 120D

𝐸𝐿 166.8544 373.6515 -485.337 787.9704 456.5101
𝐸𝑆(97.5%) 11,927.67 15,651.61 22644.77 27191.66 38483.33
𝑅𝑃𝑉01 3.80 3.80 3.80 3.80 3.80
𝑠(0; 5𝑌, 5𝑌, 5𝑌) 0.0346 0.0346 0.0346 0.0346 0.0346
𝑉𝑎𝑅(97.5%) 9717.139 13249.76 19241.79 24207.44 32828.37
𝐸𝐶𝑎𝑝(97.5%) 11760.81 15277.96 23130.11 26403.69 38026.82

Table 2: Clayton copula with 𝜃 = 1.5

Feature\Horizon 10D 20D 40D 60D 120D

𝐸𝐿 257.1059 339.3887 479.6667 290.6003 988.4948
𝐸𝑆(97.5%) 11,871.35 18,394.19 25,402.66 28,961.28 38,560.99
𝑅𝑃𝑉01 3.761188 3.761188 3.761188 3.761188 3.761188
𝑠(0; 5𝑌, 5𝑌, 5𝑌) 0.03732 0.03732 0.03732 0.03732 0.03732
𝑉𝑎𝑅(97.5%) 9,856.366 15,701.7 22,164.8 26,059.23 34148.25
𝐸𝐶𝑎𝑝(97.5%) 11,614.24 18,054.8 24,922.99 28,670.68 37572.5

Table 3: Normal copula with correlation matrix 𝜌

Feature\Horizon 10D 20D 40D 60D 120D

𝐸𝐿 166.8544 373.6515 -485.337 787.9704 456.5101
𝐸𝑆(97.5%) 11927.67 15651.61 22644.77 27191.66 38483.33
𝑅𝑃𝑉01 3.796094 3.796094 3.796094 3.796094 3.796094
𝑠(0; 5𝑌, 5𝑌, 5𝑌) 0.034571 0.034571 0.034571 0.034571 0.034571
 𝑉𝑎𝑅(97.5%) 9717.139 13249.76 19241.79 24207.44 32828.37
𝐸𝐶𝑎𝑝(97.5%) 11760.81 15277.96 23130.11 26403.69 38026.82

Table 4: Student copula with correlation matrix 𝜌 and 5 degrees of freedom:

Feature\Horizon 10D 20D 40D 60D 120D

𝐸𝐿 -147.796 18.09496 -373.337 716.0377 403.2523
𝐸𝑆(97.5%) 11,669.73 16159.06 23564.17 30,115.53 36,952.92
𝑅𝑃𝑉01 3.802218 3.802218 3.802218 3.802218 3.802218
𝑠(0; 5𝑌, 5𝑌, 5𝑌) 0.035451 0.035451 0.035451 0.035451 0.035451
𝑉𝑎𝑅(97.5%) 9,706.87 13810.56 19768.38 26166.29 33,238.06
𝐸𝐶𝑎𝑝(97.5%) 11,817.53 16140.97 23937.5 29399.49 36549.67

CDX on entities with different outstanding notional and expiries

Suppose we have 𝑛 entities with outstanding notionals 𝑁𝑖 and recovery rates 𝑅𝑖 , and the default times
𝜏𝑖 , 𝑖 = 1, 𝑛. The credits expire at times 𝑇𝑖 (expressed in years).

The notional outstanding is 𝑁𝑡 (𝑢) = ∑𝑛𝑖=1 𝑁𝑖 ⋅ 1(𝜏𝑖 ≥ 𝑢) ⋅ 1(𝑢 ≤ 𝑇𝑖 )

The loss at time 𝑢 starting at time 𝑡 can be seen as 𝐿𝑡 (𝑢) = ∑𝑛𝑖=1 𝑁𝑖 ⋅ (1 − 𝑅𝑖 ) ⋅ 1(𝜏𝑖 ≤ min(𝑢, 𝑇𝑖 ))

The spread of the CDX can then be computed similarly as in the previous case.

Numerical example:

Suppose a bank wishes to write a CDX on 3 credits whose outstanding notionals are 1⁡million, 2⁡million
and 3 million euros respectively. The credits expire in 5 years, 7 years and 9 years respectively.

The recovery rates are 70%, 50% and 30%. The default intensities (in annual noting) are 5%, 8% and 11%.

Table 1: Independent exponential default times

Feature\Horizon 10D 20D 40D 60D 120D

𝐸𝐿 -233.36607 -92.1084 67.72603 -1097.41 -10.6176
𝐸𝑆(97.5%) 18,843.5307 24128.13 37098.35 39947.11 58732.26
𝑅𝑃𝑉01 3.79609437 3.796094 3.796094 3.796094 3.796094
𝑠(0; 5𝑌, 7𝑌, 9𝑌) 5.23% 5.23% 5.23% 5.23% 5.23%
𝑉𝑎𝑅(97.5%) 15,370.2442 21,436.32 30016.62 35,516.96 48,904.05
𝐸𝐶𝑎𝑝(97.5%) 19,076.8967 24,220.24 37,030.62 41,044.51 58,742.87

Table 2: Recovery rates are 50%

 Feature\Horizon 10D 20D 40D 60D 120D
𝐸𝐿 105.283148 369.1346 197.5813 570.8626 402.5145
𝐸𝑆(97.5%) 16,342.4022 22488.02 28,008.89 33851.73 47,314.85
𝑅𝑃𝑉01 3.79609437 3.796094 3.796094 3.796094 3.796094
𝑠(0; 5𝑌, 7𝑌, 9𝑌) 4.41% 4.41% 4.41% 4.41% 4.41%
𝑉𝑎𝑅(97.5%) 13,470.9262 18920.94 24224.25 30684.37 40,979.14
𝐸𝐶𝑎𝑝(97.5%) 16,237.1191 22118.89 27811.31 33280.87 46,912.33

If the recovery rates are equally 50% then the CDX spread would be 4.40%-4.50%

If the recovery rates are 70%, 50% and 50% the spread would be 4.21%.

Feature\Horizon 10D 20D 40D 60D 120D

𝐸𝐿 -117.15999 -76.2503 -417.078 -719.079 -278.932
𝐸𝑆(97.5%) 13595.8943 20485.09 26441.99 33691.74 44901.11
𝑅𝑃𝑉01 3.79609437 3.796094 3.796094 3.796094 3.796094
𝑠(0; 5𝑌, 7𝑌, 9𝑌) 4.21% 4.21% 4.21% 4.21% 4.21%
𝑉𝑎𝑅(97.5%) 11900.1891 16138.87 23402.66 28636.83 38767.77
𝐸𝐶𝑎𝑝(97.5%) 13713.0543 20561.34 26859.07 34410.82 45180.04

Diffusion models for CDX

Option pricing approaches for CDOs

Assume a portfolio with 𝑛 credits and at time 𝑡 we want to measure the cumulative loss up to time 𝑢 as
𝐿𝑡 (𝑢) = ∑𝑛𝑖=1 𝑁𝑖 (1 − 𝑅𝑖 )1{𝜏𝑖 ≤ 𝑢} whereas the loss of the tranche [𝐴, 𝐷] is considered
[𝐴,𝐷]
𝐿𝑡 (𝑢) = (𝐿𝑡 (𝑢) − 𝐴) ⋅ 1(𝐴 ≤ 𝐿𝑡 (𝑢) ≤ 𝐷) + (𝐷 − 𝐴) ⋅ 1(𝐿𝑡 (𝑢) > 𝐷) where 𝐴, 𝐷 are the attachment
and detachment point respectively (𝐴 < 𝐷) expressed in $

This can be also considered as a call spread with the underlying the losses of the portfolio and the strike
prices 𝐴(𝑙𝑜𝑛𝑔), 𝐷(𝑠ℎ𝑜𝑟𝑡) (if 𝐴 > 0)
[𝐴,𝐷]
If 𝐴 = 0, then 𝐿𝑡 (𝑢) = value of an asset-or-nothing put + a cash-or-nothing call

The nominal outstanding amount of the tranche is therefore:

𝐷 − 𝐴, 𝐿𝑡 (𝑢) ≤ 𝐴
[𝐴,𝐷] [𝐴,𝐷]
𝑁𝑡 (𝑢) = (𝐷 − 𝐴) − 𝐿𝑡 (𝑢) = {𝐷 − 𝐿𝑡 (𝑢), 𝐿𝑡 (𝑢) ∈ [𝐴, 𝐷]
0, 𝐿𝑡 (𝑢) > 𝐷

In case 0 < 𝐴 < 𝐷, this is a put spread with strike prices 𝐴, 𝐷 (long put with strike A and expiry 𝑇 + short
put with strike 𝐷 and expiry T).

If 𝐴 = 0 (junior tranche), the notional outstanding can be simply considered as a put price long with
strike price 𝐷 and expiry at 𝑇 (the common expiries of the credits underlying the CDO).
CDOs with tranches having equal expiries
Stochastic discounted values of the premium and default legs:
𝑡𝑚
[𝐴,𝐷]
𝑆𝑉𝑡 (𝑃𝐿) = 𝑐 [𝐴,𝐷] ∑ Δ𝑡𝑚 𝑁𝑡 (𝑡𝑚 )𝑒𝑥𝑝(− ∫ 𝑟𝑠 𝑑𝑠)⁡
𝑡𝑚 ≥𝑡 𝑡

[𝐴,𝐷] 𝑡
𝑆𝑉𝑡 (𝐷𝐿) = ∑𝑡𝑚≥𝑡 Δ𝐿𝑡 (𝑡𝑚 ) ⋅ exp⁡(− ∫𝑡 𝑚 𝑟𝑠 𝑑𝑠)

Therefore the spread of the CDO tranche is:

(𝐴,𝐷)
𝐸[∑Δ𝐿𝑡 (𝑡𝑚 )𝐵𝑡 (𝑡𝑚 )]
𝑠 [𝐴,𝐷] = [𝐴,𝐷]
𝐸[∑𝑡𝑚≥𝑡 Δ𝑡𝑚 ⁡𝑁𝑡 (𝑡𝑚 )⋅𝐵𝑡 (𝑡𝑚 )]

Numerical example:

Suppose that an investor has 3 bonds with outstanding notionals of 𝑁1 = 300,000$, 𝑁2 =

200,000$, 𝑁3 = 100,000$ and the default times are considered to be modellable as exponential
random variables: 𝐸(0.05 = 𝜆1 ), 𝐸(𝜆2 = 0.08), 𝐸(𝜆3 = 0.11)⁡

The interest rate is 4.5% for all terms.

The recovery rates in case of defaults are considered 60%, 50%, 40% (there is no recovery risk).

The bonds expire in 5 years and are bullet-type.

Assume that we structure these bonds into a CDO with 3 tranches:

1. Junior Tranche (𝐴1 = 0, 𝐷1 = 40,000$) (attachment and detachment point)

2. Mezzanine tranche: (𝐴2 = 𝐷1 = 40,000$, 𝐷2 = 140,000$)
3. Senior tranche: (𝐴3 = 𝐷2 = 140,000$; 𝐷3 = +∞)

The results for the 3 tranches are given in the table below (at a 10-day investment horizon)

Feature\Tranche Junior Tranche Mezzanine Senior

𝑬𝑳 1508.498 -93.539 -98.755
𝑬𝑺𝟗𝟕.𝟓% 108313.888 49549.490 5137.889
𝑹𝑷𝑽𝟎𝟏 5.000 4.421 4.384
𝒔 24.21% 11.43% 1.38%
𝑽𝒂𝑹𝟗𝟕.𝟓% 95138.866 42584.647 4391.394
𝑬𝑪⁡𝑪𝒂𝒑(𝟗𝟕. 𝟓%; 𝑬𝑺) 106805.390 49643.029 5236.644

For the 20-day horizon we have the following results:

Feature\Tranche Junior Tranche Mezzanine Senior

𝑬𝑳 -289.88 238.16 117.08
𝑬𝑺𝟗𝟕.𝟓% 141,362.35 65,982.88 7,898.54
𝑹𝑷𝑽𝟎𝟏 5.00 4.42 4.38
𝒔 24% 11% 1%
 𝑽𝒂𝑹𝟗𝟕.𝟓% 120989.82 55154.59 6,470.47
𝑬𝑪⁡𝑪𝒂𝒑(𝟗𝟕. 𝟓%; 𝑬𝑺) 141,652.23 65,744.72 7,781.46

CDOs with tranches having different expiries

Suppose we want to price a CDO with 3 layers (junior, mezzanine and senior tranches) which have
expiries 𝑇1 < 𝑇2 < 𝑇3 and outstanding notionals are 𝑁1 , 𝑁2 , 𝑁3

So the attachment and detachment points are (0, 𝑁1 ), (𝑁1 , 𝑁1 + 𝑁2 ), (𝑁1 + 𝑁2 , 𝑁1 + 𝑁2 + 𝑁3 )

The cumulative loss can be written as follows:

3

∑ 𝑁𝑖 (1 − 𝑅𝑖 )1(𝜏𝑖 ≤ 𝑢), 𝑢 ≤ 𝑇1
𝑖=1
𝐿𝑡 (𝑢) = 3

𝑁1 (1 − 𝑅1 )1(𝜏1 ≤ 𝑇1 ) + ∑ 𝑁𝑖 (1 − 𝑅𝑖 )1(𝜏𝑖 ≤ 𝑢), 𝑢 ∈ (𝑇1 , 𝑇2 ]

𝑖=2
{𝑁1 (1 − 𝑅1 )1(𝜏1 ≤ 𝑇1 ) + 𝑁2 (1 − 𝑅2 )1(𝜏2 ≤ 𝑇2 ) + 𝑁3 (1 − 𝑅3 )1(𝜏3 ≤ 𝑢), 𝑢 > 𝑇2
Once a portion expires at time 𝑇𝑖 , at a later time, the default of that portion is measured with respect to
the expiry time 𝑇𝑖

In a simplied and more general manner, 𝐿𝑡 (𝑢) = ∑𝑛𝑖=1 𝑁𝑖 (1 − 𝑅𝑖 )1(𝜏𝑖 ≤ min(𝑢, 𝑇𝑖 ))

[𝐴1 ,𝐷1 ]
The loss of the tranche [𝐴1 , 𝐷1 ] is 𝐿𝑡 (𝑢) = (𝐿𝑡 (𝑢) − 0) ⋅ 1(𝐿𝑡 (𝑢) < 𝑁1 ) + 𝑁1 ⋅ 1(𝐿𝑡 (𝑢) > 𝑁1 )
,𝐷 [𝐴 ]
More generally, as previously, 𝐿𝑡 𝑖 𝑖 (𝑢) = (𝐿𝑡 (𝑢) − 𝐴𝑖 ) ⋅ 1(𝐴𝑖 ≤ 𝐿𝑡 (𝑢) ≤ 𝐷𝑖 ) + (𝐷𝑖 − 𝐴𝑖 )1(𝐿𝑡 (𝑢) >
𝐷𝑖 ) where 𝐴𝑖 = 𝑁1 + ⋯ + 𝑁𝑖−1 , 𝐷𝑖 = 𝑁1 + ⋯ + 𝑁𝑖
[𝐴,𝐷]
The notional outstanding at time 𝑢 can be written as 𝑁𝑡 (𝑢) = (𝐷 − 𝐴) − 𝐿[𝐴,𝐷]
𝑡 (𝑢)

The notional outstanding for the junior tranche at time 𝑇1 is:

[𝐴1 ,𝐷1 ] 𝐷1 − 𝐿𝑡 (𝑇1 ), 𝐿𝑡 (𝑇1 ) < 𝐷1 = 𝑁1

𝑁𝑡 (𝑇1 ) = {
0, 𝐿𝑡 (𝑇1 ) > 𝐷1 = 𝑁1
[𝐴1 ,𝐷1 ]
At any time 𝑢 > 𝑇1 , 𝑁𝑡 (𝑢) = 0

NUMERICAL EXAMPLE:

Assuming we are in the same situation as in the previous paragraph, but instead the expiries are 6 years,
5 years and 6 years, respectively and a 5-year CDO is issued with annual premium payments.

Feature\tranche Junior Tranche Mezzanine Senior

𝑬𝑳 -3.678 -60.145 6.569
𝑬𝑺𝟗𝟕.𝟓% 4956.961 5300.832 1044.627
𝑹𝑷𝑽𝟎𝟏 4.476 4.426 4.385
𝒔𝒑𝒓𝒆𝒂𝒅 29.07% 13.18% 1.66%
𝑽𝒂𝑹𝟗𝟕.𝟓% 4087.428 4493.632 880.197
Diffusion models for CDOs

CLOs
CLOs can be treated as particular cases of CDOs (even though the underlying assets of CLOs are loans
while the underlying assets of CDOs are mainly bonds).

CLOs are mainly ABS with two tranches: equity and senior tranches.

Because CLOs have loans as underlying assets, technically CLOs are CDOs with amortization schemes.

Mathematical framework

Similar to CDOs, the cumulative loss at time 𝑢⁡can be written as 𝐿𝑡 (𝑢) = ∑𝑁𝑖 (𝑢)(1 − 𝑅𝑖 )1(𝜏𝑖 ≤ 𝑢)

The individual notionals 𝑁𝑖 (𝑢) are no longer constant, as in a standard CDO, but depend on the
amortization scheme.

The remaining steps for pricing and valuation are identical with the one from standard CDOs.

Numerical example:

Suppose we have the same situation as in the previous paragraph.

The annual default intensities are 𝜆1 = 5%, 𝜆2 = 8%, 𝜆3 = 11%

The amortization schemes consist of annual repayments of principal, and the CLO expires in 5 years.

Table 1: CLO results with 300,000$, 200,000$, 100,000$ notional outstanding, 𝜎(𝑠𝑝𝑟𝑒𝑎𝑑) = 20%, 𝐴0 =
0, 𝐴1 = 40000, 𝐴2 = 140,000, 𝐷3 = 300,000 (3rd detachment point)

Feature\tranche Junior Mezzanine Senior

𝑬𝑳 -7.821 -0.113 0.013
𝑬𝑺𝟗𝟕.𝟓% 244.829 81.292 0.634
𝑹𝑷𝑽𝟎𝟏 4.352 4.367 4.377
𝒔 1.6% 0.2% 0.0%
𝑽𝒂𝑹 196.022 66.726 0.531

Use credit default swaps and basket default swaps to mitigate credit risk
I will show how to adjust the Simplified Approach when we have credit insurance derivatives as
hedging instruments.

In the standard approach we have 𝑅𝑊𝐴 = (𝐸𝐴𝐷 − 𝐶) ⋅ 𝑅𝑊 + 𝐶 ⋅ max⁡(20%, 𝑅𝑊𝐶 )

If the hedging instruments’ lifetime does not match the credits’, then a maturity mismatch might apply:
min(𝑇𝐺 ,𝑇,5)−0.25
𝐶𝐴 = 𝐶 ⋅ min(𝑇,5)−0.25
where 𝑇, 𝑇𝐺 is the residual maturity of the exposure and the collateral (or
guarantee)

Example 1:
Consider a 10-year credit of 100 million $ given by bank A to corporate B, rated BBB.

To protect itself against the potential default of B, bank A buys protection from bank C, rated A+, under
the form of a CDS with 4 years to expiry, on 60 million $.
min(10,4,5)−0.25 min(10,4,5)−0.25
Then 𝑅𝑊𝐴 = (100 − 60 ⋅ min(10,5)−0.25
) ⋅ 100% + 60 ⋅ min(10,5)−0.25
⋅ 50% = 76.31 million $

If the CDS would last at least 5 years, no maturity adjustment is needed so the RWA would be 𝑅𝑊𝐴2 =
(100 − 60) ⋅ 100% + 60 ⋅ 50% = 70 million $

Example 2:

Suppose a bank grants three credits of 𝑁1 = 50, 𝑁2 = 60, 𝑁3 = 70 million euros with expiry in 10 years.
All debtors have 𝐵𝐵⁡rating. The default intensities have been estimated to be 700 bps, 900 bps, 1100
bps per year.

Suppose one wishes to use a first-to-default swap on the three entities to hedge against one of the
defaults, which lasts 𝑇 years and is written on 50 million euros.

Then the adjustment would apply to all exposures, with weighted probabilities.

𝑅𝑊𝐴 = (50 − 𝐶𝐴 ⋅ 𝑃(𝜏1:3 = 𝜏1 )) ⋅ 100% + (60 − 𝐶𝐴 ⋅ 𝑃(𝜏1:3 = 𝜏2 )) ⋅ 100%

+ (70 − 𝐶𝐴 ⋅ 𝑃(𝜏1:3 = 𝜏3 )) ⋅ 100% + 𝐶𝐴 ⋅ 50%
min(10,𝑇,5)−0.25
Where 𝐶𝐴 = 50 ⋅
min(𝑇,5)−0.25

𝜆1 1 11
It can be deduced that 𝑃(𝜏1:3 = 𝜏1 ) = = 25.92%, 𝑃(𝜏1:3 = 𝜏2 ) = , 𝑃(𝜏1:3 = 𝜏3 ) = =
𝜆1 +𝜆2 +𝜆3 3 27
40.74%
If 𝑇 ≥ 5,⁡then the adjustment is not needed. In case the First to default swap is applied then the𝑅𝑊𝐴 =
155⁡million $.

If no FtD Swap is being used, then the RWA is the sum of the credits, that is 180 million euros.

If a CDS on the first credit would be used, the RWA = (50 − 50) ⋅ 100% + 60 ⋅ 100% + 70 ⋅ 100% +
50 ⋅ 50% = 155 million euros.

An approach to compute RWA when CDS and guarantees are

simultaneously used
METHODOLOGY

Step 1: We compute the adjusted EAD* by using comprehensive approach (with haircuts)

Step 2: We apply the formula 𝑅𝑊𝐴 = (𝐸𝐴𝐷 − 𝐶𝐴 ) ⋅ 𝑅𝑖𝑠𝑠𝑢𝑒𝑟 + 𝐶𝐴 ⋅ max⁡(𝑅𝑊𝐶 , 20%) where 𝐶𝐴 =
adjusted notional of the CDS or the insurance derivative.
EXAMPLE:

A 10-year credit is issued by a bank A to corporate B, rated A.

The notional is 100 million $. The credit has two collaterals: 5 million $ cash deposit and 5 million $ gold
deposit.

The bank also buys a 30 million $ of a 7-year CDS on B, from a bank rated AA.

In order to compute the EAD* I apply a comprehensive approach that is modified:

𝐸𝐴𝐷 ∗ = 100 − 5 ⋅ (1 − 15%) − 5 = 90.75 million $

A haircut of 15% on the gold deposit is used according to Basel II and III accords.

So, if we use the CDS as protection, the RWA becomes 𝑅𝑊𝐴 = (90.75 − 30) ⋅ 50% + 30 ⋅ 20% =
30.375 + 6 = 36.375
Without any guarantee or protection, 𝑅𝑊𝐴 = 50% ⋅ 100 = 50𝑚𝑛$

With guarantees: 𝑅𝑊𝐴 = (100 − 5 − 5) ⋅ 50% + 5 ⋅ max(𝑅𝑊𝑐𝑎𝑠ℎ , 20%) + 5 ⋅ max(𝑅𝑊𝑔𝑜𝑙𝑑 , 20%) =

47𝑚𝑛$
With CDS: 𝑅𝑊𝐴 = (100 − 30) ⋅ 50% + 30 ⋅ 20% = 35 + 6 = 41𝑚𝑛$

REMARK: A CDS would be more effective in reducing the required capital than the guarantees.

See also:
https://www.scribd.com/document/675256817/Pricing-CDS-Using-Credit-Transition-Matrices