5. Credit Default Swaps

Question 1

Explain ‘Credit Default Swaps (CDS)’.

Answer 1

A credit default swap (CDS) is essentially an insurance contract. If a credit event occurs, the credit protection buyer gets compensated by the credit protection seller. To obtain this coverage, the protection buyer pays the seller a premium called CDS spread. The protection seller is assuming (i.e. long) credit risk, while the protection buyer is short credit risk. Note that the CDS not provide protection against market-wide interest rate risk, only against credit risk. The contract is written on a face value of protection called the notional principal.

Question 2

Explain ‘Single Name CDS’.

Answer 2

In the case of a single-name CDS, the reference obligation is the fixed-income security on which the swap is written, usually a senior unsecured obligation (in the case of a senior CDS). The issuer of the reference obligation is called the reference entity. The CDS pays off not only when the reference entity defaults on the reference obligation but also when the reference entity defaults on any other issue that is ranked pari passu (i.e. same rank) or higher. The CDS payoff is based on the market value of the cheapest-to-deliver (CTD) bond that has the same seniority as the reference obligation.

The cheaper-to-deliver bond is the debt instrument with the same seniority as the reference obligation but that can be purchased and delivered at the lowest cost.

Question 3

Describe ‘credit events’ and settlement protocols with respect to CDS.

Answer 3

A default is defined as the ocurrence of a credit event. Common types of credit events specified in CDS agreements include:

• Bankruptcy: a bankruptcy protection filing allows the defaulting party to work with creditors under the supervision of the court so as to avoid full liquidation
• Failure to pay: occurs when the issuer misses a scheduled coupon or principal payment without filing for formal bankruptcy
• Restructuring: occurs when the issuer forces its creditors to accept terms that are different than those specified in the original issue

In the case of physical settlement, the protection seller receives the reference obligation (i.e. the bond) and pays the protection buyer the notional amount.

In the case of a cash settlement, the payout amount is the payout ratio times the notional principal.
Payout ratio = 1 - recovery rate(%)

Question 4

Explain ‘hazard rate’ and ‘survival rate’.

Answer 4

• Hazard Rate or conditional probability of default: the probability of default given that it has not already ocurred
• Survival Rate = (1-hazard rate(t1)…(1-hazard rate(tn)

Question 5

Explain ‘protection leg’, ‘premium leg’ and ‘upfront payment’.

Answer 5

The payments made by the protection buyer to the seller are the premium leg. On the other side of the contract, the protection seller must make a payment to the protection buyer in case of default; these contingent payments make up the protection leg.

The difference between the present value of the premium leg and the present value of the protection leg determines the upfront payment.

Upfront payment (by protection buyer) = PV(protection leg) - PV(premium leg)

UpfrontPremium% = (CDSspread - CDScoupon) * durationCDS