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Hedging CDS in foreign currency

Posted: December 23rd, 2010, 3:59 pm
by pimpel
I have a bond in my domestic currency issued by a foreign company. There are CDSs available for the issuer, but these are denominated in foreign currency only. Assume, that the basis between CDS spread and Z-spread derived from asset swaps is zero. I would assume, that I can extract the PD from foreign CDS and use it for valuation of bonds of that issuer in other currencies, as if default happens on the issuer, due to cross default feature it will work. That is just maths. The question is, how would you use those CDSs for hedging? Say that you have a CDS in USD and you want to hedge your bond in EUR. Entering into Cross Currency Basis Swap does not sound to me efficient since I will bear the cost of FX fluctuations. Any idea?

Hedging CDS in foreign currency

Posted: December 24th, 2010, 8:26 am
by prodiptag
why do you think xccy is inefficient, I think that is the only way to manufacture an domestic CDS from a foreign CDS (yes, dynamic rebalance required, with the associated costs). on day one you buy the foreqign cds and set up a series of fx fwds accross time points spanning the issue period. thereafter your rebalancing involved mostly buying more fwds at some points and selling them at others, with net nearly zero, so fx impact should not be very severe, no? are you on the buy side or sellside? if you are not comfortable running the risks, you can do a structured trade with a sell-side -> a credit contingent swap

Hedging CDS in foreign currency

Posted: December 24th, 2010, 9:34 am
by katastrofa
What is pimpel going to do with the FX forwards when there is a credit event?

Hedging CDS in foreign currency

Posted: December 24th, 2010, 9:42 am
by prodiptag
am not a credit guy, but i guess the easiest way to manufacture a dom ccy cds from a non-local ccy one is to do this -> on day1, buy the cds snd put on ur fx hedge spnning different points in time, notional at each points based on the defualt probs etc. then onwards dynamically rebalance (based on model/judgment whatever). So if your model and judgment is right, before the defualts happen almost all ur fx fwd shud be in that time buckets. of course easier said than donedo you have a smarter way to do this? then pls shoot it accross, eager to be enlightened

Hedging CDS in foreign currency

Posted: December 25th, 2010, 9:53 am
by StructCred
The first question is - what currency are you hedging to? You mentioned your bond is in your local currency. Are you happy to receive flows in this currency and just want to hedge out the credit risk? If that's the case, cross currency basis swap won't be a hedge at all. Since CDS is an unfunded instrument, it gives you very little fx risk (only for PV of the contract rather than notional). To hedge your credit risk of your bond in this case you want a quanto CDS. Some dealers will offer you quantoed protection in a few currencies (but it will cost you). Alternatively you can dynamically hedge with CDS in foreign currency. You can in theory build a full model for cross currency basis + correlated credit and hedge on that or if you assume that credit is uncorrelated to the currency pair, just hedge with notional adjusted for fx.

Hedging CDS in foreign currency

Posted: December 28th, 2010, 8:39 am
by pimpel
QuoteOriginally posted by: StructCredThe first question is - what currency are you hedging to? You mentioned your bond is in your local currency. Are you happy to receive flows in this currency and just want to hedge out the credit risk? If that's the case, cross currency basis swap won't be a hedge at all. Since CDS is an unfunded instrument, it gives you very little fx risk (only for PV of the contract rather than notional). To hedge your credit risk of your bond in this case you want a quanto CDS. Some dealers will offer you quantoed protection in a few currencies (but it will cost you). Alternatively you can dynamically hedge with CDS in foreign currency. You can in theory build a full model for cross currency basis + correlated credit and hedge on that or if you assume that credit is uncorrelated to the currency pair, just hedge with notional adjusted for fx.My functional currency is domestic and I am interested in pricing a bond issued in domestic currency by foreign entity. The quanto adjustment for the spread is probably something I need. Is the method described in this thread up to date, or methodss have evolved over time, since it is pretty old paper?Hence the domestic currency is pretty exotic, and the issuer is a multinational, I definetly may assume no correlation between default and fx. What exactly do you mean by hedging with notional adjustment for fx? would you keep notional multiplied by PD exchanged into foreign currency of a CDS?

Hedging CDS in foreign currency

Posted: December 28th, 2010, 12:14 pm
by StructCred
If correlation is zero, you can indeed just multiply you pd by fx and hedge that with tradable cds. If your default probs are correlated, you can use a model to take it into account. In both cases, your big concern is the bid-offer you'll be crossing on CDS while dynamically hedging. As such, I wouldn't worry too much about using the latest and greatest model. I'd say just assume multivariate normal for your fx and credit and hedge to a sensible corr assumption. It's not like you have any credit vol to calibrate to anyway.

Hedging CDS in foreign currency

Posted: December 28th, 2010, 12:22 pm
by pimpel
Ok, so far, so good ==> assume we have hedged dynamically the credit risk. The bond in domestic currency should include some funding premium. How to hedge that? Assume I have the basis between CDS and Z-spread derived from bonds in foreign currency. Can I hedge the level of that somehow? Should the basis be similar in both currencies?

Hedging CDS in foreign currency

Posted: December 28th, 2010, 8:33 pm
by StructCred
If you take a basis package in your domestic currency and a basis package in a foreign currency, the difference between the two should IN THEORY be equal to cross currency basis swap. In reality this doesn't always hold true. Why do you want to hedge out the bond-cds basis (even if there was an instrument to do it)? If you buy a basis package, you're generally either deploying some funding on a taking a view on that basis. If you hedge it out, you end up with a risk free instrument (assuming you're swapped to floating) and there are much simpler ways to get that.

Hedging CDS in foreign currency

Posted: December 28th, 2010, 8:51 pm
by pimpel
QuoteOriginally posted by: StructCredIf you take a basis package in your domestic currency and a basis package in a foreign currency, the difference between the two should IN THEORY be equal to cross currency basis swap. In reality this doesn't always hold true. Why do you want to hedge out the bond-cds basis (even if there was an instrument to do it)? If you buy a basis package, you're generally either deploying some funding on a taking a view on that basis. If you hedge it out, you end up with a risk free instrument (assuming you're swapped to floating) and there are much simpler ways to get that.My goal is to determine fair value of the bond in domestic currency which is not part of active market, but there is active market for bonds/cds in foreign currency. My price should be then equal to the value I can hedge using other instruments from liquid market.