Chapter 12 - Credit Swaps Flashcards
What is a basket CDS?
A CDS that offers protection on the
default probabilities of a basket of
assets.
What is a credit default swap?
The exchange of two cash flows – a
fee payment and a conditional
payment – which occurs only if certain
circumstances are met. A CDS is credit
insurance; it transfers credit risk.
What is a first-to-default CDS?
A CDS that pays upon the first default
of any of the referenced assets.
What is an index-based CDS?
Credit default swap (CDS) on an index
designed to track the credit risk of a
group of corporate entities considered
to represent a sector of the economy
or a particular geographical region.
What is a portfolio CDS?
A CDS written on a basket of
underlying assets but that has a
predetermined monetary amount,
rather than a number of defaults.
What is a protection buyer?
The party wanting to reduce credit risk
in the use of credit derivatives.
What is a protection seller?
The party wanting to acquire or
hold credit risk in the use of credit
derivatives.
What is a recovery rate?
The realizable rate of recovery of the
underlying asset(s), as determined
by an independent assessor, if a cash
settled CDS is activated.
Recovery rate is the estimated percent of a loan or an obligation that will still be repaid to creditors in the event of a default or bankruptcy.
In a firm’s capital structure, the recovery rate on senior debt will generally carry a high recovery rate, while junior debt may be relegated to a rate as low as nearly zero.
Following the wave of defaults following the 2008 financial crisis, the average recovery rate for senior unsecured bonds dropped from 53.3% in 2007 to 33.8% in 2008.
What is a reference asset?
The underlying asset(s) being
protected in a credit derivative.
What is a reference entity?
The issuer of the underlying asset(s)
being protected in a credit derivative.
What is a single-name CDS?
A plain vanilla single asset CDS,
which is basically credit protection
(insurance).
Explain what credit derivatives are.
Credit derivatives are financial instruments that have an underlying credit asset, or pool of credit assets such as
bonds, loans or mortgages. Payouts are a function of the creditworthiness of the issuer or referenced asset. They
are designed to transfer and manage credit risk exposure. The protection buyer is the party seeking to reduce or
transfer the credit risk, and the protection seller is the party seeking to acquire or hold the credit risk.
Explain the role credit derivatives play for different users including banks, insurance companies, asset
managers and securities dealers.
Credit derivatives serve multiple purposes, depending on who is holding them and for what purpose:
* Banks will use credit derivatives to hedge and will thus buy protection from counterparties. Banks do this to
enhance their credit risk management, retain ownership of loans given their increased risk level, and reduce
regulatory capital requirements. They will also sell protection when they wish to diversify their loan portfolio
and enhance yields with respect to lending.
* Insurance Companies, similar to banks, will both buy and sell protection depending on circumstances and
their portfolio makeup. They typically buy protection to mitigate liability concentrations (in effect selling
away the risk associated with concentrated liability commitments), rather than reconfiguring their liability
portfolio, which may prove difficult since some loans aren’t very marketable. They may sell protection to
increase yields and to help match assets to liabilities, particularly to match cash flows.
* Asset and Hedge Fund Managers will buy protection to manage negative expectations on positions, for
macroeconomic or sectoral reasons. They will sell protection, as other market participants will, to increase
yield and diversification given a positive credit outlook, generate leverage on existing portfolios, and establish
speculative positions.
* Securities Dealers will buy protection to cover their exposure as market makers and to more generally manage
the credit risk on their books. They will sell protection to increase yield, to better diversify their loan and asset
portfolio, and to help offset hedging costs for other credits.
Demonstrate how a standard credit default swap works.
A credit default swap (CDS) is the exchange of two cash flows: a fee payment and a conditional payment, which
occurs only if certain circumstances are met. The CDS will have value for the protection buyer only if these
conditions are met, whereas the protection seller will always receive the premiums. Think of a CDS as a type of
insurance in which default of an asset triggers payment.
If default occurs, the CDS is activated and terminates with the payment according to the predetermined
conditions of the contract. Payment can be 100% of the underlying’s face value or a percentage of the total
(nominal) CDS commitment. There are two payment modes: physical settlement (the protection buyer remits
the asset to the protection seller against full face value payment) and cash settlement (the protection buyer
retains the asset and receives the difference between face value and recovery value).
A basket CDS offers protection on the default probabilities of a basket of assets (multi-name). If the CDS pays
upon the first default of any of the referenced assets, it is a first-to-default CDS. Other types are second-to-
default and third-to-default CDSs, etc. Fees on basket CDSs, given risk diversification, are lower than equivalent
fees for individual CDSs on all assets in the basket. This makes them attractive for both protection buyers
(cheaper protection) and protection sellers (higher fees than single-asset CDSs with moderately higher risk).
A portfolio CDS is written on a basket of underlying assets as well but has a predetermined monetary
amount to be paid rather than a number of defaults. This type of CDS remains active until expiration, or the
predetermined monetary amount is reached, regardless of the actual number of defaults.
Demonstrate how an index credit default swap works.
The indices on which index CDSs are based are designed to track the credit risk of a group of corporate entities
considered to represent a sector of the economy or a particular geographical region. CDS indices prices are
calculated from the prices of the underlying constituents CDSs and have become widely accepted credit risk
benchmarks.
An index CDS is defined, among other criteria, by:
* the list of its index constituents;
* the index weight of each constituent;
* the term and maturity date of the index CDS;
* the notional amount;
* the coupon payable by the protection buyer; and
* the specific credit events that would trigger a settlement.
Index CDSs generally trade on a spread basis, expressed in basis points. These spreads represent the total
amount payable by the protection buyer to the protection seller. As credit quality deteriorates, quoted spreads
increase.
All index CDSs have fixed coupons attached to them, payable quarterly over the duration of the contract. The
present value of the difference between a contract coupon rate and its quoted spread is exchanged upfront at
the initiation or close of a contract.
When a credit event occurs with one of the constituents underlying an index CDS, the protection seller must
pay the protection buyer a percentage of the notional value of the index CDS corresponding to the index weight
of the constituent. This amount is adjusted by a ratio of [1 − the confirmed recovery rate of the face value of the
bond in default].
Formula: Notional × index weight of the constituent × [1 − the recovery rate] = amount payable by the
protection seller to the protection buyer on default of one constituent.
The notional amount used for calculations is then reduced by a factor corresponding to the index weight of the
constituent in default and the number of constituents in the index is reduced by one, the constituent in default
