CDS

Question 1

Ways of settlement

Answer 1

Cash AND Physical (protection buyer gives loan, gets cash in credit event)

Question 2

Cash settlement -> what gets paid?

Answer 2

face value minus RR, calculated based on dealers quotes or market price after event

Question 3

Elements affecting CDS price

Answer 3

1) PD
2) exp. RR
3) maturity of CDS
4) PD of protection seller (counterparty risk)
5) correlation between default of reference entity and protection seller
6) presence of CTD options for protection buyer

Question 4

How to replicate CDS

Answer 4

Use ASP: long fixed rate bond, financed by shorting bond on repo market at LIBOR + S1, enter into IRS (pay C, receive Libor+S2). This replicates payoff of CDS

Question 5

No arbitrage spread of CDS according to ASP approach

Answer 5

should be S2-S1 (S2 spread from asset swap, S1 spread from repo market)

Question 6

Definition basis

Answer 6

CDS_spread - (IRS_S2 - Repo_S1) -> should be zero

Question 7

Why is CDS basis not zero?

Answer 7

1) technical differences in payoff structure
2) liquidity in CDS and bond market
3) market participants in the 2 amrkets
4) frictions in repo market

Technical:

1) CTD
2) counterparty risk differentials
3) transactionc costs of ASP

Question 8

3 ways of unwinding CDS

Answer 8

1) agreeing an unwind payment to original CDS counterparty
2) assignemtn to another counterparty that replaces the investor in the CDS
3) offsetting tarnsaction with another counterparty

Question 9

MtM of CDS position

Answer 9

CF you can get from current market conditions - CF that you are paying

Question 10

Components of MtM a CDS

Answer 10

We need model for 1) survival prob 2) RR

1) intensity-based (reduced-form) models or structural models -> first time a jump occurs in a jump process in intensity model
2) from rating

Question 11

Intensity-based models, pros and cons

Answer 11

Pros: elegant, use default-free term structure modeling, easy to estimate

Cons: no economic clues what drives default, no signal on how far a company is from default

Question 12

Jarrow Turnbull with various intensities

Answer 12

credit event = first event of a Poisson counting process.
i1) ntensity lambda is constant. survival probabilities have sae structure as discount factors

2) Cox process -> lambda varies randomly (like bond pricing formula with short rate = intensity)
3) time-varying determinisitc intensities: lambda(t) is piecewise function of time (e.g. steps each year) -> lambda(t) independent of interest rates and RR

Question 13

Hazard rate

Answer 13

1 - surv. prob.

h(t) = prob. given survival until t

Question 14

Structural models: key idea

Answer 14

value of firms assets follow stochastic process. if below certain threshold (normally function of firms debt) -> default.

-> relationship between firms assets and det provide info on PD and RR

Question 15

Structual models: pros and cons

Answer 15

Pros: intuitive/true, provides link amongst values of different asset classes

Cons: accounting data needed

Question 16

Merton model: assumptions

Answer 16

firm as equity and debt
debt is pure discount bond with payment at T
value of firm is tradable asset and follow lognormal diffusion with constant vola and interest rate

Question 17

definition equity in merton model

Answer 17

call on firm asset value with strike=book value of debt

Question 18

PD in merton

Answer 18

N(-d_2) from BS

Question 19

Merton: EV, DV, implied credit spread, PD depend on what?

Answer 19

Leverage L, T, asset volatility

Question 20

Merton: drawbacks

Answer 20

1) company can only default at T -> PD=0 for any t credit spread behaves accordingly
2) all debt mapped into a single ZCB
3) interst rates assumed to be constant, no term structure
4) value of firm tradable - however, parameters not even observable

Question 21

KMV: default point

Answer 21

point at which firm defaults. somewhere between total liabilities and short-term liabilities

Question 22

KMV: disance to default (DD)

Answer 22

number of standard deviations the asset value is away fom default: (A_t - DP) / A_t*sigma_A

Question 23

KMV expected default frequency

Answer 23

Prob. of AV falling below DP

Question 24

KMV: where get the data?

Answer 24

take from database -> historical default and bankruptcy frequencies etc. (resulting distribution has wider tails than normal)