A note on replicating a CDS through a repo and an asset swap

TL;DR

This paper demonstrates how to replicate a credit default swap using a repurchase agreement and an asset swap with a specific termination clause, utilizing valuation adjustment formulas.

Contribution

It introduces a method to replicate CDS using repos and asset swaps with a zero close-out clause, providing a practical replication approach.

Findings

Replication method for CDS using repos and asset swaps

Pricing of the break clause with valuation adjustments

Simplified approach to CDS replication

Abstract

In this note we show how to replicate a stylized CDS with a repurchase agreement and an asset swap. The latter must be designed in such a way that, on default of the issuer, it is terminated with a zero close-out amount. This break clause can be priced using the well known unilateral credit/debit valuation adjustment formulas.