CDS Premium

[GioKe]

"If the CDS spread increases, the premium paid by the fixed-leg counterparty increases. This causes a gain to existing fixed-leg payers, who in retrospect got into their positions cheap" from :P2.T6.308. Credit default swap (CDS) spread curves (Malz section 7.3)

Should'nt the premium remain the same as it is agreed upon before the event? Therefore the fact that the fixed leg is paying the same premium for protection that would now be more expensive constitute the "gain" on the position?

 

[Kavita.bhangdia]

Yes you are right , the premium would be the same.. But if someone else buys CDS on the same counterparty, they will have to pay more.. Say I bought potatoes at $10/lb. Now the price has gone up and you are paying $15/lb..

So , i have gained in this transaction relative to you..

I can sell you for $15/lb

Thanks
Kavita

 

[GioKe]

Yeah just the way it was worded I guess. I would say "If the CDS spread increases, the premium for CDS protection increases"

 

[Mkaim]

Hi GioKe,

I see it as a fixed for float arrangement, similar to a swap. The counterparty receiving the fixed and paying the floating premium ("fixed-leg counterparty") would have to pay more than they did in the previous period because the floating premium increased. This party is long the fixed bond and short the floater and the payoff would be fixed value - floater value (floating has now increased in price). Their loss will the gain of the "floating-leg counterparty" who is receiving the floater and whose payoff is floater - fixed where the floater now has increased in value. But I can see how the "fixed-leg counterparty" and the "floating-rate counterparty" can lead to some confusion.

 

[GioKe]

ahh. Ok I was under the impression that fixed-leg counterparty meant paying fixed. So when you read "fixed leg counterparty" you look at it in terms of what you receive. I'm suprised I havent caught that in the past. Thanks.

 

[Mkaim]

ahh. Ok I was under the impression that fixed-leg counterparty meant paying fixed. So when you read "fixed leg counterparty" you look at it in terms of what you receive. I'm suprised I havent caught that in the past. Thanks.

Well you have to be careful. In my experience it has been worded in several ways, each one of which is equally confusing. In terms of this question, you just have to know that there is such a thing as a fixed for float CDS and David gives enough detail as to which party is receiving the fixed rate or the floating (irrespective of what he's calling them). Hope this helps.