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Volume 4 Number 3, Fall 2008 Research Papers Valuing LCDS cancelability Terry Benzschawel
Citi Markets and Banking, 388 Greenwich Street, New York, NY 10013, USA; email: terry.l.benzschawel@citi.com Julio DaGraca
Citi Markets and Banking, 388 Greenwich Street, New York, NY 10013, USA; email: julio.dagraca@citi.com Abhinav Kamra
Citi Markets and Banking, 388 Greenwich Street, New York, NY 10013, USA; email: abhinv.kamra@citi.com Joe Yu
Citi Markets and Banking, 388 Greenwich Street, New York, NY 10013, USA; email: joe.yu@citi.com American style loan credit default swap (LCDS) contracts are terminated if the underlying class of reference loan obligations cease to exist. Historical analyses indicate that firms retire their loan debt frequently and this most often occurs when improvements in obligors’ credit quality allows them to borrow at lower rates in the unsecured debt market. We estimate loan cancellation probabilities from historical rating transitions, assuming that when a high-yield credit becomes investment grade it will repay its loans. Spread values are calculated for non-cancellable and cancellable LCDS by adjusting the premiums of the fee legs to match their contingent legs and we adjust the non-cancellable spreads upward by the ratios of those spreads. Comparison of our model predictions with market-implied spread adjustments suggests that the model is a viable one for estimating the spread value of LCDS cancellability. Cancellation rates from the model underestimate those implied by firms’ loan buybacks, and although the data may overestimate cancellation rates, it highlights the importance of cyclical factors in cancellation rates. Finally, we provide a formula for approximating the spread value of cancellation and present a table of percentage cancellation adjustments for user input probabilities of annual cancellation and default rates.
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