Fixed Income

Quantitative Credit Research

7 August 2003

Up-front Credit Default Swaps

Dominic O’Kane and Saurav Sen

When bonds are distressed, protection is often quoted as an up-front payment rather than a “running”
spread paid until the earlier of default or maturity. This article examines the pricing, risk profile and
performance of up-front credit default swaps and compares them to the standard running trades.
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Up-front Credit Default Swaps

Dominic O’Kane When bonds are distressed, protection is often quoted as an up-front payment rather than
+44-20-7260-2628 a “running” spread paid until the earlier of default or maturity. This article examines the
dokane@lehman.com pricing, risk profile and performance of up-front credit default swaps and compares them
to the standard running trades. We also address the issue of how an investor can decide
whether to trade on an up-front or a running basis.1
Saurav Sen
+44-20-7260-2940
sasen@lehman.com 1. INTRODUCTION
In the standard credit default swap (CDS), the protection buyer pays for protection by
making regular spread payments to the protection seller until the earlier of a credit event
or maturity of the contract. We call this a running CDS as the protection payments run
throughout the life of the contract. However, when the reference credit is distressed,
protection-sellers quote prices on an up-front basis. This means that protection buyers
make only a single up-front payment at initiation in return for protection against a credit
event (typically these are bankruptcy, failure to pay and restructuring) until the contract
maturity date. These contracts are also usually entered into for short maturities, i.e. up to
one year.
Paying for protection up-front has the effect of changing the risk profile of the default
swap contract in two fundamental ways. First, it front loads the timing of cashflows to the
start of the trade, which has implications in terms of the interest rate risk, funding and
carry. Second, it removes the credit risk in the payment of the premium in the standard
CDS, which terminates following a credit event.
It should be noted that buying a bond and buying protection on the same face value is not
a credit-neutral strategy when the bond is trading away from par. See O’Kane and
McAdie (2001) for a discussion. While a default swap offers principal protection, the net
P&L of a trade, which incorporates coupons, funding costs and the cost of protection, is
strongly dependent on the timing of the credit event that triggers protection. This effect is
most pronounced when the issuer is distressed, and applies to both running and up-front
trades.
The aim of this article is to set out in detail the mechanics and risks of the up-front CDS
contract. In particular, we wish to highlight the differences between up-front and running
CDS so that the investor can easily see which is more suitable for expressing a specific
credit view. We begin by describing the precise mechanics of the up-front contract.
Following this, we set out the model for pricing up-front protection and discuss
calibration issues. We then examine the risk sensitivities of up-front CDS and compare
these to running CDS. We also discuss default swap basis trades using up-front CDS and
consider when up-front may be preferred to running.

2. UP-FRONT PROTECTION

2.1. Mechanics of Up-front Protection

An up-front CDS is a contract that enables an investor to buy protection against the risk
that an underlying reference entity suffers a credit event. Unlike a standard CDS, where it
costs nothing to enter into the contract, the protection buyer in an up-front CDS makes a
single initial payment to the seller, in return for protection until a specified maturity date.

1
Reprinted from Quantitative Credit Research Quarterly, Volume 2003-Q3.

August 2003 Please see important analyst(s) certifications at the end of this report. 1
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Equally, an investor can use the up-front contract to sell protection in return for a single
initial payment. The investor is then assuming the credit risk of the reference credit until
the maturity date of the contract.
If default occurs before maturity, the protection buyer typically delivers assets with a face
value equal to that of the protection, to the protection seller in return for the face value
amount in cash. Alternatively, the protection may be settled in cash format, exactly as in a
standard running CDS. The value of protection delivered is equivalent to par minus
recovery, where recovery is the price of the cheapest-to-deliver (CTD) asset in the basket
of deliverables2.
More details on the exact definitions of credit events and the mechanics of delivering
protection can be found in O’Kane (2001). Figure 1 shows a schematic representation of
the cashflows in running and up-front CDS contracts.

Figure 1: Comparison of cashflows for running and up-front default swaps.

Protection Seller

Up-front Payment

Running Spread

Time

Running

Up-front
Protection Buyer

100-R on Credit Event

2.2. Up-front versus Running Trades

The difference between up-front and running CDS is in the premium leg: in the former
case the cost of protection is delivered as a single amount paid at initiation, whereas in
the latter it takes the form of a risky coupon stream which lasts until a credit event or
maturity, whichever occurs sooner.
This difference in the timing of cashflows enables investors to take a view on the timing
of default, as mentioned in the Introduction, and also changes the risk profile of up-front
trades relative to running. As we explain below, up-front protection is priced so that, on a
present value basis, an investor should be indifferent between running and up-front
trades. The up-front price equals the arbitrage-free expected value of the risky coupon
stream in a running CDS. However, the different timing of cashflows changes the
distribution of outcomes; hence, the decision to trade on running or up-front basis also
depends on the investor’s risk preferences. These concepts are illustrated with examples
in the next section.
There are a number of reasons why dealers prefer to quote distressed credits in up-front
format:

2
See “Valuation of Restructuring Credit Event in Credit Default Swaps”, O’Kane, Pedersen and Turnbull, Lehman
Brothers Quantitative Credit Research Quarterly, May 2003.

August 2003 2
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

1. They eliminate any uncertainty about the size and timing of the payment for
protection.
2. The distribution of outcomes from an up-front contract is typically narrower for an
up-front CDS than for a running CDS. This is especially true when spreads are wide.
For this reason, risk aversion makes protection sellers and buyers prefer up-front to
running. This will be explained in detail later.
3. Dealers may feel more uncomfortable quoting spreads in excess of 1000bp, which is
what would be required for many distressed credits. This is also the regime in which
bonds begin to trade on a price basis. It is no surprise that the same should happen to
CDS.
4. Very wide spreads may also pose problems for analytics unless carefully
implemented. For example, the payment of the accrued premium following a credit
event has a significant effect and must be implemented correctly.
An investor’s preference for up-front or running trades, therefore, also depends on the
valuation and price sensitivity of up-front trades. Before discussing these, we describe
some examples to fix ideas and motivate the remainder of the article. These examples
illustrate the mechanics of up-front protection and also highlight the market views and
risks implicit in such trades.

3. UP-FRONT TRADES
As with running CDS, up-front CDS can be used to implement basis trades between the
cash and CDS market. They can also be used to express views on the likely timing of
default and expected spread movements. To discuss these, it is best to use an example and
for this we will use a 5-year maturity, 6% coupon bond which pays annually.
Suppose initially this bond was distressed, trading at a clean price of $75 with an up-front
premium quoted at $33 on a face value of $100. As we will show in the next section, the
model-implied CDS spread corresponding to this up-front price, assuming a 40%
recovery rate, is 1050bp.
The generic basis trade will consist of an investor being long the bond and long
protection on the same face value via either a running or up-front CDS. For simplicity,
we will assume that the bond and running CDS cashflow dates are synchronized. We also
assume that the funding rate and reinvestment rates are Libor flat at a constant 3%.
We now examine the differences between running and up-front trades in terms of
cashflows, carry and MTM for a range of scenarios.

3.1. Scenario I: Reference Credit Survives to Maturity

Table 1 shows the protection buyer’s cashflows in the event that the bond does not
default, when protection is bought on an up-front basis. Cashflows to the investor are
shown with a positive sign.

August 2003 3
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Table 1: Long Bond + Long Up-front Protection (No-default Scenario)

Reinvested carry
Time (Y) Bond ($) Upfront CDS ($) Funding ($) NET ($)
($)
0 -75.00 -33.00 108.00 0.00 0.00
1 6.00 0.00 -3.24 2.76 2.76
2 6.00 0.00 -3.24 2.76 5.60
3 6.00 0.00 -3.24 2.76 8.53
4 6.00 0.00 -3.24 2.76 11.55
5 106.00 0.00 -111.24 -5.24 6.65

As Table 1 shows, buying up-front protection results in a positive carry trade. In each
period, the net carry is $2.76 per $100 face, which is the difference between the 6%
coupon earned on the bond, and the 3% funding paid on a total initial borrowing of $108
($75 for the bond + $33 up-front protection). The last payment is negative, as the investor
has to pay back the funding principal, but the total reinvested carry over the life of the
trade is still positive.
Contrast this with Table 2 below, which shows the cashflows when protection is bought
on a running basis. This is a negative carry trade, since the total payments in each period,
consisting of $10.50 running protection and $2.25 bond funding, exceed the $6 coupon
income from the bond. Even though the last cashflow is positive to the investor, the net
reinvested carry is still negative.

Table 2: Long Bond + Long Running Protection (No-default Scenario)

Reinvested carry
Time (Y) Bond ($) Running CDS ($) Funding ($) NET ($)
($)
0 -75.00 0.00 75.00 0.00 0.00
1 6.00 -10.50 -2.25 -6.75 -6.75
2 6.00 -10.50 -2.25 -6.75 -13.70
3 6.00 -10.50 -2.25 -6.75 -20.86
4 6.00 -10.50 -2.25 -6.75 -28.24
5 106.00 -10.50 -77.25 18.25 -10.84

In this scenario, a protection buyer who expects the reference credit to survive but wishes
to hedge his downside “just in case”, would prefer to pay for protection in up-front form
rather than a running spread, in order to avoid locking in a high contractual spread for the
life of the trade.

3.2. Scenario II: Reference Credit Defaults After One Year

Table 3 shows the cashflows for a protection buyer in a basis trade if a credit event occurs
one year after the trade date, and the issuer defaults with 35% recovery. The protection
has been purchased in up-front format. We have assumed that the credit event happens
just after the first coupon date.

August 2003 4
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Table 3: Long Bond + Long Up-front Protection (Default Scenario)

Reinvested carry
Time (Y) Bond ($) Upfront CDS ($) Funding ($) NET ($)
($)
0 -75.00 -33.00 108.00 0.00 0.00
1 6.00 0.00 -3.24 2.76 2.76
DEFAULT 35.00 65.00 -108.00 -8.00 -5.24

Following the credit event, the protection buyer receives $35 from the sale of the
distressed bond and $65 from the up-front CDS, but has to repay the funding principal of
$108, resulting in a net negative cashflow of $8. The reinvested carry from the trade is
therefore a negative -$5.24.
Compare this to a protection buyer who chooses to trade on a running basis. This is
illustrated in Table 4 below in the same scenario as above.

Table 4: Long Bond + Long Running Protection (Default Scenario)

Running CDS Reinvested carry

Time (Y) Bond ($) Funding ($) NET ($)
($) ($)
0 -75.00 0.00 75.00 0.00 0.00
1 6.00 -10.50 -2.25 -6.75 -6.75
DEFAULT 35.00 65.00 -75.00 25.00 18.25

The protection payout following the credit event is the same as in the up-front case, but
the funding principal to be repaid is $75, which nets a positive cashflow of +$25 to the
protection buyer. The net reinvested carry from the trade is therefore $18.25.
The protection buyer does better in the running CDS format. As a result, protection
buyers who have a view that default is almost certain should prefer to trade on a running
CDS format. Protection sellers who view default as imminent should prefer to trade on an
up-front basis.

3.3. Scenario III: Bond Rallies Sharply In Three Months

Consider now a scenario where the bond price rallies from $75 to $92 in three months.
Suppose the quoted running spread for the issuer now stands at 495bp, which corresponds
to an up-front price of $18.50. To illustrate this, Table 5 shows the unwind value of the
trade three months after the trade date, if protection is purchased on an up-front basis.

Table 5. Unwind Value of Up-front Trade (Bullish Scenario)

Time (Y) Bond ($) Upfront CDS ($) Funding ($)

0 -75.00 -33.00 108.00

0.25 92.00 18.50 -108.81 MTM ($)
UNWIND 17.00 -14.50 -0.81 1.69

We see that the gain in the value of the bond has been almost exactly offset by the fall in
the value of the up-front CDS and the funding.
Compare this with the case of running protection. The presence of a risky premium leg
makes the unwind value of a running CDS more sensitive to spread movements than an

August 2003 5
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

up-front CDS. For this reason, the adverse impact of spread tightening is more
pronounced as shown below in Table 6.

Table 6. Unwind Value of a Running Trade (Bullish Scenario)

Time (Y) Bond ($) Running spread PV01 Funding ($)

0 -75.00 1050 bp 75.00

0.25 92.00 495 bp 3.5277 -75.56 MTM ($)
UNWIND 17.00 -$19.58 -0.56 -3.14

Here we see that the loss due to the spread tightening is greater than the increase in the
bond price. It shows that a protection buyer would have been better off buying up-front
protection on the trade date since this exhibits lower spread sensitivity than a running CDS.

3.4. Variation in Outcomes: Running versus Upfront

Table 7 summarizes the relative performance of running and up-front trades for various
scenarios including the ones described above. Two clear conclusions can be drawn from
the various outcomes. First, we see that buying a bond and buying protection is not a
credit-neutral strategy, and the timing of the credit event has a significant influence on the
net P&L of a trade. Indeed we see that a trade can switch from being positive value-on-
default to negative value-on-default depending on the timing of a credit event.
Additionally, we see that the absolute size of the gain or loss is greater for running than
for up-front trades. This means that investors should choose to trade on a running or an
up-front basis depending on the strength of their view and their risk preferences.

Table 7. P&L of Trades: Upfront versus Running (Various Scenarios)

Scenario Running ($) Upfront ($)

Issuer survives to maturity -10.84 6.65
Credit event in 1 year 18.25 -5.24
Credit event in 4 years -7.42 3.55
Spreads tighten -3.14 1.69
Spreads widen 1.84 -1.81

In each case shown the investor has hedged the bond’s face value and so has full principal
protection. However, the longer the issuer survives, the better the performance of an
upfront trade relative to running for a protection buyer, and vice-versa for a protection
seller. If protection is triggered in one year, the running trade has a higher P&L than the
up-front trade. As the timing of the credit event recedes, the performance of the up-front
trade improves relative to running, as the running spread paid eventually exceeds the
initial cost of up-front protection. Beyond a point, the P&L of the up-front trade exceeds
that of the running trade.
We now turn to the formal valuation and marking to market of up-front protection trades
and discuss their sensitivity to various market factors.

August 2003 6
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

4. VALUATION OF UP-FRONT PROTECTION

One starting point for valuing up-front protection is to attempt to use the cash market as a
reference. For example, suppose that a 5-year bond with a 5% coupon trades at a price of
$85 when risk-free rates are 3%. How much should an investor pay for up-front
protection?
To investigate the economics of the trade, suppose the investor was quoted $15 for up-
front protection. The initial cost of the bond plus protection would be $100. There are two
possible outcomes:
Credit Event: The investor receives all the coupons up to the time of the credit event and
then receives par (in return for delivering the defaulted asset to the protection seller).
No Credit Event: The investor receives all of the remaining coupons plus par.
In both cases, the investor has received 200bp over the risk-free rate for assuming no
credit risk (we ignore the counterparty risk of the protection seller). The only difference is
that there is uncertainty regarding the timing of the principal payment since this is at the
maturity date of the contract or the time of the credit event. This trade presents an
arbitrage as it implies that the investor should pay more than $15 for up-front protection.
To determine how much more, we need a valuation model which can reconcile both the
pricing of bonds and up-front CDS.

4.1. Valuation Model

The value of the up-front CDS is the expected present value of the contingent payment of
(100%–R) made on the face value of the protection following a credit event. This is
simply the value of the protection leg in the standard CDS, where we define R as the
expected price of the Cheapest To Deliver (CTD) obligation following a credit event.
Let the current date be time t and consider the problem of pricing an up-front default
swap maturing at time T. The value of up-front protection is then given by the discounted
expectation of (100%-R) at the time of the credit event. This can be written as:

 T

U (t , T ) = E Q (1 − R ) ∫ Z (t , s )Q (t , s )λ ( s ) ds  (1)
 t 
where

λ(s) is the hazard rate, the instantaneous probability of default in the period [s,s+ds]
conditional on surviving to time s. This is usually assumed to be deterministic and
independent of interest rates. See O’Kane and Turnbull (2003) for a discussion.

Q(t,s) is the arbitrage-free survival probability of the reference entity from valuation
time t to time s.

Z(t,s) is the Libor discount factor from valuation date t to time s.
The next step is to calibrate this model in order to value the up-front protection. There are
essentially three ways to do this, which we describe next.

4.2. Calibration of Survival Probabilities

Calibration within a risk-neutral framework involves determining the term structure of
survival probabilities which refits the market prices of traded assets. There are a number
of ways to do this.

August 2003 7
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Survival Probabilities from CDS Spreads

This most straightforward approach, which should enforce consistent pricing within the
CDS market, is to bootstrap a term structure of survival probabilities using the term
structure of spreads in the CDS market as described in O’Kane and Turnbull (2003). This
assumes the existence of quoted CDS spreads which may not be the case when the credit
is trading distressed.

Survival Probabilities from Bond Prices

An alternative is to use bond prices. However, we need a valuation formula for bonds
which allows us to do so, and this is shown in the appendix. In this case, it is also possible
that a bootstrapping approach may not be appropriate, especially when bonds exist with
similar maturities but different coupons and prices. Calibration in these circumstances
may be best achieved using some best-fit approach. Care should be taken to remove
default swap basis effects.

Survival Probabilities from Up-front Prices

The observed price of up-front protection can also be used to extract survival
probabilities. In this case, we use Equation (1) to invert prices and extract survival
probabilities. This can allow us to price up-front CDS to other maturities.

4.3. Example
Assuming a recovery rate of 40%, a flat 3% risk-free rate, a flat3 hazard rate, a 5-year
bond trading with a 5% annual coupon and a price of $85 implies a term structure of
survival probabilities. Substituting these results into the up-front pricing formula gives us
a value for the up-front protection of $22. Observe that this is greater than par minus the
full price of the bond, i.e. $15 (= $100–15).
This is exactly what we expected from our observation in the example at the start of this
section, where we noted that an up-front value of $15 presents an arbitrage. The value of
the up-front implicitly should be greater to take into account the coupon payments on the
bond which would be paid. As a result, the investor who buys the bond and buys up-front
must pay $85+$22=$107. The $7 represents the expected present value of the coupon
payments on the bond. Just to be clear, the valuation equation (1) of the up-front does not
explicitly know about the coupons on the bond. However, it implicitly knows about the
bond since the survival probabilities have been calibrated to the bond price.

5. SENSITIVITY ANALYSIS OF UP-FRONT PROTECTION

The inputs into the valuation of up-front protection are the interest rate term structure; the
CDS spread curve and a recovery rate assumption. The question to be answered next is:
what is the sensitivity of the up-front protection value to these inputs?

5.1. Sensitivity to Interest Rates

The value of up-front protection is the value of (100%-R) paid following a credit event.
The value of this decreases with increasing interest rates as shown in Figure 2.

3
This is the simplest assumption we can make, but it may not be realistic as a distressed credit typically has a
downward sloping hazard rate term structure.

August 2003 8
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Figure 2. Dependence of Up-front Price on Interest Rates

21.00

20.00

19.00

Upfront Price
18.00

17.00

16.00

15.00

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%
Interest Rate

5.2. Sensitivity to CDS Spreads

Figure 3 shows the dependence of the up-front price on the CDS spread level. As
expected, the up-front price increases with increasing CDS spread, since the protection
seller has to be compensated for the greater likelihood of default. As spreads increase and
default becomes inevitable, the cost of up-front protection tends to (100%-R). This is
clear in Figure 4, where we have shown recovery rates of 30% and 50%.

Figure 3. Up-front Price vs. CDS Spread for 5-year maturity

80.00
R = 30%
70.00

60.00
Upfront Price

50.00

40.00 R = 50%

30.00

20.00

10.00

0.00
0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

Spread

5.3. Sensitivity to Recovery Rates

Figure 4 shows the up-front price as a function of recovery rate, where we have assumed
a flat term structure of CDS spreads at 500bp and one at 1500bp. As the recovery rate
increases, two things happen. First, the default probability increases since we have fixed
the CDS spread (at low spreads the probability of default is roughly equal to S/(1-R)).

August 2003 9
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

However, the protection amount paid on default (1-R) decreases. These effects tend to
cancel out for low spreads, though for high spreads (>1000bp) the effect can be material.

Figure 4. Up-front Price vs. Recovery Rate

50.00

45.00

40.00 S = 1500 bp
35.00

Upfront Price
30.00

25.00

20.00

15.00
S = 500 bp
10.00

5.00

0.00
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
Recovery Rate

5.4. Sensitivity to Maturity

Figure 5 shows the variation in up-front price with protection maturity. The value of
protection clearly increases monotonically with maturity since the protection buyer is
protected for a longer period. Assuming a flat spread curve, the value of protection is
asymptotically equal to
λ
U ∞ = (1 − R ) ,
λ+r
where the hazard rate λ is approximately linked to the spread and recovery rate
assumption via the Credit Triangle relationship S= λ(1-R). If the spread curve is flat, the
credit triangle is a surprisingly good approximation. For example, the up-front price of
protection to a maturity of 20 years, assuming a recovery rate of 40% and flat spreads of
1250bp is $52.18 per $100 face. The credit triangle approximation estimates this at
$52.44. The error becomes smaller as maturity increases.

August 2003 10
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Figure 5. Up-front Price vs. Maturity

60.00
S = 1500 bp
50.00

40.00

Upfront Price
30.00
S = 500 bp

20.00

10.00

0.00

10

12

14

16

18
Years to Maturity

What we have shown so far is the sensitivity of the up-front price to a number of
important parameters. For those trading up-front CDS, we need to determine the
sensitivity of the mark-to-market to market factors. This is addressed in the next section.

6. VALUING AN UP-FRONT POSITION

Valuing an up-front protection trade is different to marking to market a running CDS.
The difference is due to the fact that the upfront trade is funded while the running is
unfunded. For a running CDS trade, ignoring the coupons paid or received, the P&L of
the trade is the MTM of the contract described elsewhere (O’Kane and Turnbull 2003).
However, the value of an upfront trade is the value of what is paid or received if the
contract is unwound minus the value paid for the upfront. This may incorporate funding
costs for the initial payment of upfront protection.

6.1. Computing the Up-Front Position Value

Consider an investor who has sold protection on an up-front basis at time 0 for T years at
a price U(0,T). Let t be the current valuation date. If U(t,T) is the remaining value of
protection between t and T, then the value of the position is given by:
UF UF
M Short ( t , T ) = U( t , T ) − U (0, T) = − M Long

This is because U(t,T) is the cost of entering into an offsetting position on the reference
credit at time t. However this ignores the cost of funding or investing the upfront
payment.

6.2. Funding Issues

Unlike a running CDS, which costs nothing to set up, an upfront CDS involves an initial
payment to the protection seller. The cost of funding (in case of a long protection
position) or the value of reinvestment (in case of short protection) must therefore be taken
into account, when evaluating the P&L of a trade.

August 2003 11
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Consider the position of an investor selling protection on an up-front basis. At time 0, the
investor receives U(0,T). Assuming that this is reinvested at Libor flat, the investor’s
wealth at time t is given by
U(0, T) ⋅ B(0, t )

where B(0,t) is the value of a dollar continuously reinvested at Libor between 0 and t. If,
at time t, the investor enters into an offsetting contract, buying up-front protection for the
remaining time from t to T at the price U(t,T), then the net gain or loss from this trade is

PLUF
S ( t , T ) = U(0, T )B(0, t ) − U( t , T )

For a long protection position, assuming that the funding of the initial payment of U(0,T)
is also done at Libor flat, we have

PLUF UF
L ( t , T ) = U( t , T ) − U (0, T ) ⋅ B(0, t ) = − M S ( t , T )

Clearly, different borrowing and lending rates can break this symmetry.

6.3. Comparison with Running CDS

It is important to compare the value of an up-front CDS contract to the value of the
equivalent running CDS contract. The present value of a running long protection position
initially traded at time 0 at a contractual spread of S(0,T) with maturity T and which has
been offset at valuation time t with a position traded at a spread of S(t,T) is given by the
value of the protection leg minus the expected present value of the premium leg of the
CDS.

M RUN
L ( t , T) = U ( t , T) − S(0, T ) ⋅ RPV 01( t , T )
= [S( t , T) − S(0, T )] ⋅ RPV 01( t , T)

where RPV01(t,T), is the present value at time t of a 1bp premium stream which
terminates at the earlier of maturity time T or default. See the references for a discussion
of the MTM of running default swaps.
The difference is clear. In both cases the protection buyer is long the protection which is
worth U(t,T). This will change in value as spreads, interest rates and recovery rate
assumptions change.
The difference is in the premium leg. In an up-front contract, all the market information
from the trade date to maturity is incorporated into a single initial payment U(0,T). This
has no sensitivity to any subsequent market inputs and no exposure to future interest
rates, credit spreads or recovery rates.
In contrast, the spread leg of the standard CDS is sensitive to all of these market variables
since it is the discounted expectation of risky spread payments. In other words, in an
upfront trade the investor has already paid (or received payment) for the remaining
protection, worth U(t,T), whereas in a running trade part of the payment, which is
contractually fixed at time 0, this payment is made between t and min[T,τ] where τ is the
time of the credit event.
For an investor using up-front CDS to buy or sell credit risk, it is essential to understand
how sensitive the valuation of the position is to changes in market variables. We now
examine the sensitivity of running and upfront trades to spreads and interest rates.

August 2003 12
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

6.4. Sensitivity to Spreads

Both the MTM of an up-front and running long protection CDS increase as spreads
widen, since the implied default probability increases and so the value of the protection
increases. However, a running CDS is more sensitive to spread changes than an up-front
CDS, since both the premium and the protection legs are sensitive to spread changes.
The MTM of a running CDS is dependent on two opposing factors. Recall, the MTM of a
long protection position is given by

M RUN
L ( t , T) = [S( t , T) − S(0, T)] ⋅ RPV 01( t , T )

As low market spreads, the value of the MTM is negative. As the value of S(t,T)
increases, the risky PV01 decreases. As the spread increases beyond S(t,T)=S(0,T), the
MTM becomes positive. This is shown in Figure 8.

Figure 8. Relative Spread Sensitivity of the MTM of Up-front and Running CDS.

80.00
Running
60.00
MTM (Long Protection)

40.00

20.00 Upfront

0.00

-20.00

-40.00

-60.00
0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

Spread

We see the same sort of behavior for the up-front protection. However, the slope of the
running CDS curve is different to that of the up-front CDS because the running CDS has
a risky PV01 effect – at low spreads the risky PV01 is high, while for high spreads the
risky PV01 is low. This makes the running protection more negative at lower spreads and
more positive at high spreads. At very high spreads the upfront CDS value tends
asymptotically to (1-R)-U(0,T) while that of the running CDS tends to (1-R) since the
value of the premium leg tends to zero.

6.5. Interest Rate Sensitivity

Figure 9 compares the interest rate sensitivity of MTM for up-front and running CDS as
spreads change. The IR01 is defined as the change in the value for a long protection
position for a 1bp parallel change in the Libor curve. There is a fundamental difference
between running and up-front which is that in a running CDS both legs of the contract
trade have an interest rate sensitivity.

August 2003 13
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

Figure 9. Interest Rate Sensitivity of MTM for Running and Up-front Trades

0.02

0.01

IR01 (Long Protection)

0.01
Running

0.00

-0.01

-0.01
Upfront

-0.02

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000
Spread

At low spreads the MTM of the running CDS is negative so that an increase in interest
rates increases the value of the contract and the IR01 is positive. The interest rate
sensitivity of the MTM of the up-front CDS is only to the contingent incoming payment
of (100%-R) and so is negative. However, at very high spreads the sensitivity to interest
rates of both contract types tends to zero as they both tend to contracts paying a certain 1-
R immediately.

7. CONCLUSIONS
Up-front CDS trades are common for short-dated and distressed bonds. For protection
sellers, they are attractive as a means to lock in the PV of protection as a sure payment
rather than a risky cashflow stream. For protection buyers, they offer the opportunity for
better carry trades and a way to avoid being locked into paying high spreads. If the issuer
survives, an up-front trade will outperform a running trade.
The relative performance of running and up-front trades depends on whether a credit
event occurs and when. Which is chosen should reflect the investor’s view. We
summarise the main conclusions below.
• Buying a bond and buying protection is not a credit-neutral trade. The net P&L
depends on the timing of the credit event, and an investor’s P&L can be significantly
different depending on whether protection is bought on an up-front or running basis.
• A protection buyer who expects the reference credit to survive, but wishes to hedge
downside risk “just in case”, should prefer to pay for protection in up-front form
rather than as a running spread. This is in order to avoid locking in a high contractual
spread for the life of the trade.
• Protection buyers who have a view that default is almost certain should prefer to trade
on a running CDS format since the spread will only be paid until the credit event. For
the same reason, protection sellers who view default as imminent should prefer to
trade on an up-front basis.
• A protection buyer who is taking a strong view on a spread movement should prefer a
running CDS as this exhibits a higher spread sensitivity than an upfront CDS. Equally
the downside can be greater.
Up-front trades can therefore be used to express a view on the timing of a credit event,
and also take exposure to a different risk profile than running trades.

August 2003 14
Lehman Brothers | Quantitative Credit Research QCR Quarterly, vol. 2003-Q3

REFERENCES
Berd, Mashal and Wang (2003), Estimation of Implied Default and Survival Probabilities
from Credit Bond Prices, Lehman Brothers QCRQ, August 2003.
Jarrow and Turnbull (1995), Pricing Derivatives on Financial Securities Subject to Credit
Risk, Journal of Finance, Vol 50 (1995), 53-85.
O’Kane (2001) Credit Derivatives Explained, Lehman Brothers, March 2001.
O’Kane and Schloegl (2001), Modelling Credit: Theory and Practice, February 2001.
O’Kane and McAdie (2001), Trading the Basis, Risk Magazine, October 2001.

8. APPENDIX
Given that a bond and a credit default swap are linked to the same reference entity, cross
default provisions mean that they should default together and so have the same term
structure of survival probabilities Q. Suppose the full price at time t of a bond issued by
the same issuer as the reference credit, maturing in T years and paying an annual coupon
rate of C, is given by B(t,T). If coupons are paid semi-annually, the model-based
valuation formula for a bond is given by

C n M
B( t, T ) = ∑
2 j=1
Z( t, t j )Q( t , t j ) +Z( t, T)Q( t , T) + R ∑ Z( t, t m )(Q( t , t m −1 ) − Q( t , t m ))
m =1

The first term is the sum of the risky discounted coupons. The second term is the PV of
the principal repaid at maturity, weighted by the probability that the issuer survives to
maturity. The third term is the PV of the price of the bond after a credit event, R, which is
realised if the credit event occurs before maturity. We have assumed the issuer defaults at
M discrete times and that coupons default with no recovery.
The survival probabilities can now be calibrated to a term structure of bond prices using
some best-fit technique. See Berd, Mashal and Wang (2003) for details of a fitting
approach.

August 2003 15
Lehman Brothers Fixed Income Research analysts produce proprietary research in conjunction with firm trading desks that trade
as principal in the instruments mentioned herein, and hence their research is not independent of the proprietary interests of the
firm. The firm’s interests may conflict with the interests of an investor in those instruments.
Lehman Brothers Fixed Income Research analysts receive compensation based in part on the firm’s trading and capital markets
revenues. Lehman Brothers and any affiliate may have a position in the instruments or the company discussed in this report.
The views expressed in this report accurately reflect the personal views of Dominic O’Kane and Saurav Sen, the primary
analyst(s) responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst(s)’
compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein.
The research analysts responsible for preparing this report receive compensation based upon various factors, including, among
other things, the quality of their work, firm revenues, including trading and capital markets revenues, competitive factors and
client feedback.

To the extent that any of the views expressed in this research report are based on the firm’s quantitative research model,
Lehman Brothers hereby certify (1) that the views expressed in this research report accurately reflect the firm’s quantitative
research model and (2) that no part of the firm’s compensation was, is or will be directly or indirectly related to the specific
recommendations or views expressed in this report.

This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved by Lehman
Brothers International (Europe), regulated by the Financial Services Authority, in connection with its distribution in the European Economic Area. This material is distributed
in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australia by Lehman Brothers Australia Pty
Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This document is for information purposes only and it should not be regarded as an offer to sell or
as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any manner without the written
permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or complete and it should not be relied upon
as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of Lehman Brothers
and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable
for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers’ representative. The value of and the income
produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates, interest rates,
or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may be used to pay that
income. Lehman Brothers may make a market or deal as principal in the securities mentioned in this document or in options, futures, or other derivatives based thereon.
In addition, Lehman Brothers, its shareholders, directors, officers and/or employees, may from time to time have long or short positions in such securities or in options,
futures, or other derivative instruments based thereon. One or more directors, officers, and/or employees of Lehman Brothers may be a director of the issuer of the
securities mentioned in this document. Lehman Brothers may have managed or co-managed a public offering of securities for any issuer mentioned in this document
within the last three years, or may, from time to time, perform investment banking or other services for, or solicit investment banking or other business from any company
mentioned in this document.
 2003 Lehman Brothers. All rights reserved.
Additional information is available on request. Please contact a Lehman Brothers’ entity in your home jurisdiction.