Credit Linked Swap

ORE defines the product as follows:

A credit linked swap is a swap where the payments are contingent on credit events occurring for a reference CDS.

Source: ORE User Guide, Products catalogue, creditlinkedswap.tex.

ORE describes three classes of payments. One class pays only if no credit event has occurred for the reference CDS until the payment date. Another class pays when a credit event has occurred. Its amount is weighted by the recovery rate or by the loss given default rate, either actual or fixed by the trade. The third class pays independently of any credit events. Payment of the contingent classes can fall on the default date, the period end, or the trade maturity, per the trade terms.

A credit linked swap is a swap with a trigger. Most of the time it pays like a normal swap. If a named credit defaults, some payments change or stop. The structure lets one side pass a credit risk into a swap format.

The trade uses a CreditLinkedSwapData block. A CreditCurveId names the referenced CDS credit curve. A ReferenceInformation node can stand in for it. The payment legs are grouped by class. The IndependentPayments legs pay regardless of credit events. The ContingentPayments legs pay only if no credit event has occurred until the payment date. The DefaultPayments and RecoveryPayments legs pay when a credit event has occurred. A FixedRecoveryRate sets a fixed recovery when given. Otherwise the market recovery rate is used. DefaultPaymentTime controls when the default-dependent legs pay, at default, at period end, or at maturity. The underlying legs can pay any kind of coupon, fixed rate, Ibor, CMS, or fixed amounts.

Each class of leg prices with its own survival assumption. The independent legs are plain swap legs. The contingent legs pay only while the reference survives. The default and recovery legs pay on the credit event, scaled by recovery or loss given default. The trade is a hybrid of swap cash flows and credit protection cash flows.

• The credit curve of the reference CDS. It drives the survival and default probabilities.
• The discount curve of the payment currency.
• The recovery assumption, actual or fixed.
• The legs of each class. Their coupons, rates, and notionals set the payment sizes.
• The timing of the default-dependent payments.

The credit sensitivity follows the direction of the contingent legs. The swap sensitivity follows the independent legs.

A credit event rewrites the trade. The default and recovery legs settle. The contingent legs stop paying where the terms say so. Until then, the trade ages like a swap with a survival trigger. Near maturity the remaining contingent exposure narrows. At maturity all classes stop with the last payments.

A bank structures a swap so that part of its exposure to a credit is shared or hedged. The product links a funding or investment swap to credit protection in one contract. In ORE Studio a customer books credit linked swaps to value them and run sensitivities on the ORE engine.

ORE's catalogue shows a trade with the four leg groups:

<CreditLinkedSwapData>
  <CreditCurveId>RED:46A844|SNRFOR|USD|XR14</CreditCurveId>
  <SettlesAccrual>false</SettlesAccrual>
  <FixedRecoveryRate>0.4</FixedRecoveryRate>
  <DefaultPaymentTime>atDefault</DefaultPaymentTime>
  <IndependentPayments>
    <LegData> ... </LegData>
  </IndependentPayments>
  <ContingentPayments>
    <LegData> ... </LegData>
  </ContingentPayments>
  <DefaultPayments>
    <LegData> ... </LegData>
  </DefaultPayments>
  <RecoveryPayments>
    <LegData> ... </LegData>
  </RecoveryPayments>
</CreditLinkedSwapData>

Source: ORE User Guide, Products catalogue, creditlinkedswap.tex, listing Credit Linked Swap Data (leg detail abbreviated).

The example sets a fixed recovery of 40 percent. The reference curve follows the conventions of the Credit Default Swap family.