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By Sivan Mahadevan, Vishwanath Tirupattur, Peter Polanskyj, Phanikiran Naraparaju, Pinar Onur, Andrew Sheets

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Extra resources for Credit Derivatives Insights Morgan Stanley

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The combination of CDS1 and a forward default swap, which starts at the end of year 1, replicates CDS2. Therefore, by equating the two cashflow streams, we can determine the implied forward default swap level. The following equations summarize the calculation of forward CDS rates (using the same notation as we used in the CDS Pricing section): PV (CDSt ) + PV ( FWDt −T ) = PV (CDST ) where T PV (CDST ) = ¦ DFt ⋅ ST t S · § ¨1 + T ¸ −R¹ 1 © T Fi −T PV ( FWDi −T ) = ¦ DFt ⋅ t F · t =i § ¨1 + i −T ¸ © 1− R ¹ t =1 The first equation represents replication of a CDS maturity at T with a CDS of term t and a forward-starting CDS that starts at t and ends at T.

These complexities have been challenging in the definition and determination of credit events as well as settlement mechanisms. In this section, we discuss some of these complexities and their relevance to the development of an SF CDS market, drawing parallels where appropriate to the corporate credit market (Exhibit 4 summarizes the unique characteristics of SF securities and compares them to corporate bonds in the context of credit default swaps). © 2005 Morgan Stanley Reference Entity / Reference Obligation: A typical corporate CDS refers to a credit event in a reference entity, which can have multiple pari passu obligations at a given level of seniority in the capital structure.

SF CDS: SETTLEMENT MECHANISMS Upon the occurrence of a credit event, the protection buyer may deliver a credit event notice to the protection seller and settle all or any portion of the notional amount. There are essentially three settlement mechanisms for settling credit events with SF CDS – physical settlement, cash settlement and pay-as-you-go. There appears to be a “continental divide” of preferences in terms of settlement mechanisms: European transactions seem more inclined towards physical settlement with a cash settlement option, while US transactions lean towards pay-as-you-go settlements with a physical delivery option.

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