What is Factored Notional

Series on Derivatives Software System
February 6, 2012
My Book “Managing Derivatives Contracts” Released
September 30, 2014

When CDX is initiated it includes a set of reference entities (constituents or names) and notional amount which is a total protection. Each underlying name has its contribution factor towards the index. For example, one name is 1% if there are 100 names in index.

However, after a credit event in any name, the protection amount of the index will be reduced to reflect the settlement of credit event.

According to market standards, Index notional is not changed. Rather, notional is reduced by the factor while computing cash flows. This notional is known as CDX Factored Notional.

Let’s look at example – assume Index version X with 100 names has one credit event, that is – 1% reduction in notional. Assume you have a position of 100mm. When you calculate cash flows you use this factor to reduce the notional. That means

the notional used is
100mm * .99 = 99mm (Not 100mm)

So the premium paid on this is
99mm * 500bp = 4,950,000 pa (not 5,000,000) (assuming 500bps is the Index premium)(rough calculation)

It is also possible that you can change the notional on your position. But using a factor keeping the notional fixed is a more common practice.

KEYWORDS – CDX Factored Notional, Factored Notional, Credit Index Factor, Notional Factor

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  2. Michael He says:

    Clearly explained.

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