Fitch Ratings plans to publish its approach to rating collateralized debt obligations referenced to equity-default swaps next month, in a move that could lead to it publishing its criteria for the instruments. CDOs referenced to equity-default swaps have caused a debate among the rating agencies and investor community, with some claiming that they are equity products that don't belong in the credit arena while others claim the options are so far out of the money that they are driven by credit factors.
Richard Gambel, head of synthetic CDOs at Fitch in London, said it has been researching the area for some six to nine months. An equity-default swap is a barrier option with a strike usually set at around 30% of the initial value of the stock. It normally has a fixed recovery rate of 50%.
The essential components of the modeling are the characteristics of the particular equity being referenced in terms of its volatility, the strike of the default swap and the correlation to other reference entities. Fitch has already carried out extensive research on the correlation of equity prices as part of its analysis of CDO squared transactions, according to Gambel.
Gambel said any criteria or model will work with its existing VECTOR model, which is a Monte Carlo based framework used for analyzing CDOs. He added this will allow it to examine a range of equity-default swap instruments as well as hybrid credit instruments with an equity-default swap element.
