the formula

Credit Default Swap cashflows, author Ramin Na...

Credit Default Swap cashflows, author Ramin Nakisa. Photo by Ramin Nakisa. (Photo credit: Wikipedia)

Formula #1

To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give

PV\, =\, (1 - p_1) N(1-R) \delta_1\,
+ p_1 ( 1 - p_2 ) [ N(1-R) \delta_2 - \frac{Nc}{4} \delta_1 ]
+p_1 p_2 ( 1 - p_3 ) [ N(1-R) \delta_3 - \frac{Nc}{4} (\delta_1 + \delta_2) ]
+p_1 p_2 p_3 (1 - p_4) [ N(1-R) \delta_4 - \frac{Nc}{4} (\delta_1 + \delta_2 + \delta_3) ]
-p_1 p_2 p_3 p_4 ( \delta_1 + \delta_2 + \delta_3 + \delta_4 ) \frac{Nc}{4}

http://en.wikipedia.org/wiki/Credit_default_swap#Pricing_and_valuation


Formula #2

financial crisis = capture government + privatize public assets


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5 Responses to “the formula”

  1. n8chz Says:

    The probability of each outcome is a guesstimate, as is the value of R.

    • Poor Richard Says:

      If my formula #2 is correct, the purpose of formula #1 is to obfuscate risk rather than to estimate it accurately!

      • n8chz Says:

        The stated purpose of such formulas is to “price” risk. (Did you know ‘price’ is a verb?) As with all price arbitrage, the object of the game is to buy low and sell high. So when buying debt (i.e. lending) retail, get non-sub-prime borrowers to believe they’re sub-prime; while selling it wholesale, get the corrupt ratings agencies to rate it “AAA.”

        • Poor Richard Says:

          The problem is obfuscation, mostly intentional at some level of the game, that makes accurate pricing by non-PhDs impossible.

  2. Lori Says:

    J.W.Mason nailed it.


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