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Measuring Risk on Credit Indices: On the Use of the Basis
May 1, 2006
In this paper we examine the evolution of fair spreads on credit indices over 2005 and investigate the various alternatives to provide risk measures on these products. We first review the mechanics of these indices. We show how market fair spreads can be decomposed into three components: the average fair spread over the reference basket, a term representing the basket heterogeneity, and the basis. From our analysis, this basis should be understood as an additional risk factor. For a risk manager, the short lengths of available time series on credit indices is a challenging problem. Taking into account these three spread components, we describe a way to create synthetic time series of fair spreads. These synthetic fair spreads overcome the difficulty and yield reasonable risk measures.
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