An asset-backed credit default swap (ABCDS), also known as a CDS on an asset-backed security (CDS on ABS) and ABS credit default swap (ABS CDS), is a credit default swap in which the reference obligation is an asset-backed security. An ABCDS can be used to transform the credit risk away from an ABS and can also be used to short the credit risk of an ABS. On the other hand, an investor can purchase the cash ABS and buy protection and earn the difference between the cash bond spread received and ABCDS premium paid. An ABCDS has several features that a CDS does not have:
- Prepayment uncertainty. An ABS can be prepaid when the underlying assets are prepaid.
- Principal write-downs. This can happen if losses on the underlying assets exceed available credit enhancement or principal payments are used to pay any interest shortfall.
- Pay-as-you-go (PAUG) settlement. PAUG is popular in the United States. It is designed to mirror the cash flows on the underlying reference obligation. The protection seller pays any write-downs and principal or interest shortfalls experienced by the reference obligation. However, Pay-As-You-Go ABCDS is not considered in this document.
For an ABCDS, both prepayment uncertainty and principal write-downs change the notional of the underlying ABS. We assume that these uncertaintites similar to a CDS are known and given by a prepayment fraction curve.
If the underlying entity defaults, the protection seller would pay to the protection buyer, where is the default time, is the notional at time , and is the recovery rate.
The premium payments can be calculated similar to CDS except that the notional is replaced with the outstanding notional.
To evaluate an FINCAD product that can value Asset-Backed Credit Default Swaps, contact a FINCAD Representative