Lehman publishes LCDS pricing model

In its latest CDO/Structured credit monthly report, Lehman Brothers has published a model for pricing single name loan-only credit default swaps taking into account the possibility of the reference loan being cancelled. The initiative is designed to meet the need for models that capture the differences between loan-based and standard credit default swaps, and which can be extended to correlation products such as LCDX tranches.

The report points out that there is considerable disagreement about the likelihood of a loan being cancelled, since this is a rather idiosyncratic event. Lehman’s approach is to use a hazard rate model for cancellation which is conceptually similar to the way default probability is generally modelled. For the sake of simplicity, its approach assumes that default probability is independent of cancellation probability.