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Comment by trillic | Hacker News Reader

Implied probability of default over a given time-span can be approximated with the equation P = 1 - ( e ^ ( ( -S * t ) / ( 1 - R ) ) where S is the CDS spread and R is the recovery rate.

The spread can be solved using the inverse S = ln ( 1 - P ) * ( ( R - 1 ) / t )

Probabilities and rates are both expressed as percentages not basis points.

S is the spread. t is years. R is the recovery rate.

Source is my notes from undergrad. Options, Futures, and Other Derivatives (9th Edition) by John C. Hull. Take all this with a grain of salt as I am not a quant. (but I am looking for a job!)

Doing some additional reading, there are some more precise approximations but they are less general.[1]

Last number I was able to pull up the $CS CDS was trading at 551 BP. Up from 446 yesterday (an all-time high for $CS)

Lehman Bros hit 640 BP just days before collapse.

[1] https://quant.stackexchange.com/questions/15986/how-to-compu...

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What did you use as the recovery rate?

Weird thing about the recovery rate is that everyone I've asked says the same thing, and I've traded CDS: the recovery rate is 40%. It's a bit of a free variable in that equation, and it matters. Trouble is how on earth do you estimate it? But random people I've met in the business will just say 40%, for every issuer, somehow.

Sounds like the financial version of dark matter

A fudge factor that makes your models agree with observation? Yeah, pretty much. I was never an expert in CDS so I always wondered if other people had better ways of dealing with it. But nobody I've come across has ever offered anything other than 40%.

It’s not necessarily.

A peculiarity of finance as a field of study is that a lot of the people studying finance only care about direct applications and a lot of the people teaching finance had this mindset when they learnt.

It’s easy to end up with some poorly taught material. If you carefully looked at the model which gave rise to the equation you are considering, there probably is a very tangible meaning to the figure everyone is ball parking.

>> there probably is a very tangible meaning to the figure everyone is ball parking

40 is awfully close to 42

Not really. Quants modelled stochastic recovery rates and they saw that it doesn't really add much. Fixed recovery rates work just fine.

Yup 40%, it's in the textbook, and as the other commenter nicely put it, it also seems like the financial equivalent of dark matter to me.

We are living in times of idiosyncratic risk and my approximations above are likely no better than hearsay.

That being said I'm not rushing to buy or sell $CS stock even with my elevated risk tolerance and the seemingly low price.

I'm very interested in your term "idiosyncratic risk" having worked the Street and particularly fond of synthetics / swaps / GICs / etc. as a platform.

My mental picture is a very unsteady hub and spoke like in Wipeout or something where the parties and counter parties are intertwined in ways that the dynamics are, as you put it, idiosyncratic.

What do you mean by idiosyncratic risk here? It seems as though you just read the word in an online forum where it was used in an context free manner. Read through investopedia.com/terms/i/idiosyncraticrisk.asp and tell me how it applies here?

It's a bit gutsy to ask someone who casually drops a CDS valuation formula into a conversation to justify themselves against an Investopedia article, as if a retail-oriented content farm is the definitive resource on finance.

To answer your question, "idiosyncratic risk" in this context means that an individual company might have problems that don't broadly apply to the rest of its industry. For example Credit Suisse might have management that is bad at running a bank, leading to repeated investment losses and regulatory actions well beyond what's normal for big multinational banks.

Look at the CS balance sheets over the past few years, or its stock price and PE ratio, or hell just Google "Credit Suisse books loss" and look at how many times they tried to stick their fingers in the wrong cookie jar. They got hit by the Hwang thing, they got hit by Greensill, and apparently they can't even accurately report how much money they're making (losing).

I wouldn't want to have any position on their equity either.

Can those of us who aren't a bit gutsy get a translation of these super interesting points. I'm not asking for a tldr, this is fascinating shit. I'm just asking anyone who has the time and interest to teach us uninitiated about what the Hwang and Greensill things were and how this company is apparently getting their hands stuck in all the wrong financial cookie jars.

Personally I’d probably check Patrick Boyle’s videos from Youtube as a start. IMHO he tends to do a good job in summarizing these cases (bear in mind I might not be the best judge of that, of course): https://youtu.be/hhHdtDyQD90 https://youtu.be/2t4lGmNDiHo

I’d also welcome any interesting further reading on the subject!

I’m not going to stoop to your level and click your silly little link, as I don’t think there’s much investopedia can help me with this particular incident.

However, if you’d like to learn more about $CS and Archegos I’d recommend reading the Report put out by $CS on the topic.

Colloquially known as, “Credit Suisse Group Special Committee of the Board of Directors Report on Archegos Capital Management”

https://www.sec.gov/Archives/edgar/data/1159510/000137036821...

It’s all about the material risks Archegos posed to Credit Suisse.

CS failed to capture a number of specific risks which were intrinsic to Archegos’ specific trading strategy. I won’t go through them all but they explicitly call out “idiosyncratic risk” due to their use of equity total return swaps, baskets of them, to hide equity positions. The risk being if the components of the basket, which were may have been billed to be diversified, all the sudden begin to move violently and in sequence, it would be a material idiosyncratic risk to $CS.

A large number of these swaps from 2021 are coming due this week and next. Including likely a large number today, March 15, which is a commonly used date for expiry of EuroDollar and Forex contracts, as well as presumably equity swaps as well?

Now, what’s in those swaps? Who knows, the CFTC announced an exemption back in 2021 allowing NO REPORTING of swaps through at least the fall of this year, which has subsequently been extended through 2025. So we shall see how the dominoes fall and only after will they let us see how they were setup.

https://www.cftc.gov/PressRoom/PressReleases/8422-21

https://www.cftc.gov/PressRoom/PressReleases/8618-22

The 40% recovery rate isn't written down on the swaps actual terms?

Edit: I asked ChatGPT. "The recovery rate of a credit default swap (CDS) is typically specified in the contract and agreed upon by the parties involved. The recovery rate is the percentage of the notional value of the underlying debt that the protection buyer would receive in the event of a credit event, such as a default, of the reference entity.

To find the recovery rate of a specific CDS contract, you can refer to the contract documentation, which should include details on the recovery rate. This information may also be available from the CDS provider or through financial data providers such as Bloomberg, Reuters, or other financial news sources.

It's worth noting that the recovery rate can vary depending on the specific CDS contract, the reference entity, and the prevailing market conditions. Therefore, it's important to confirm the recovery rate specified in the contract and to keep track of any changes in the market or credit conditions that could affect the recovery rate."

The recovery rate is written down in the terms of the swap. You'll have to read the contract.

Coincidentally, I am in a class being conducted by John C. Hull right now as I type this comment.

Put your phone down and pay attention! ;)

Thanks for sharing this.

Quantitative finance really is a fascinating field, not because it will make you rich, but because you can dive much deeper into understand exactly what the market believes about the probability of different events.

Of course what the market believes doesn't have to be correct, but nonetheless very interesting to dive into.

Can you check how that data looked for ubs and CS before they habe been bailed out?

I am certain the Swiss government will bail them out, direct democracy be damned.

Switzerland's wealth is tied to the reputation of their banks being top tier.

Swiss bankers already lost a lot of customers to US banks, letting CS fail would have very bad consequence on Swiss economy long term

They should have another factor for government shenanigans where a entity defaults but the cds isn’t recognized as a default

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