Credit Default Swaps Flashcards
(In regards to CDS) Short position of underlying
Deteriorating credit quality - Buyer of CDS
(In regards to CDS) Long position of underlying
Improving Credit quality - Short CDS
Seller of CDS
Improving credit quality - Long underlying
Buyer of CDS
Worsening credit quality - Short underlying
CDS Buyer
Short Position of underlying credit quality
CDS Seller
Long Position
What does the credit protection buyer do in CDS?
Premium leg of the CDS
Makes a series of payments (premiums) in exchange.
What does the Credit protection seller do in CDS
Protection leg of CDS
Makes payment in the event of credit event
Singel name CDS
A CDS on a specific borrower (Reference entity)
Name the 3 different types of CDS
- Single name
- Index
- Tranche
What is Physical Settlement of a CDS?
Holder of the bond sells to CDS seller at par
What is Cash Settlement of a CDS?
Seller pays holder for losses
Swap seller -> Swap buyer
Par - Market value
Payout amount = Payout ratio x Notional amount
CDS leg: Protection Leg
Seller pays buyer
Protection seller pays protection buyer if credit event occurs
CDS leg: Premium Leg
Buyer pays seller
Protection buyer makes periodic payment to seller of protection
What is the formula for upfront payment
PV Protection leg - PV of Premium leg
PV Protection leg > PV of Premium leg
> 0
Protection Buyer pays seller
PV Protection leg < PV of Premium leg
Protection seller pays Buyer
Full formula for uprfont payment
PV Protection - PV premimum
(Spread - rate) x Duration
(Credit Spread - Fixed Coupon) x Duration
Formula for Credit Spread
Upfront payment / Duration) + Fixed Coupon rate
Formula for Profit for CDS Buyer
Change in Basis points x Duration x Notional amount
% Change in CDS price
(Formula for Profit for CDS Buyer)
Change in basis points x Duration
How is the payoff determine for CDS?
The cheapest to delivery
Regardless of TTM, always chose the bond with the lowest % value trading at par
When credit quality of the reference rate improves, what will happen to the protection leg of a CDS
Protection leg gains value, since the credit spread will be less than the premium rate
When credit quality of the reference rate deteriorates, what will happen
Premium leg gails value, the credit spread will be greater than the premium rate
Rates for investment-grade company CDS rates
1%
Rates for High-yield company CDS rates
5%
What is Credit spread?
Credit spread is the difference between the yield (return) of two different debt instruments with the same maturity but different credit ratings.
Name the 3 types of credit event
- Bankrupcy
- Failure to pay
- Restrucutring (voluntary restructuring is not a credit event)
in CDS
Who will pay if
Credit Spread < Standard Rate
Seller (premium leg) pays Buyer (Protection Leg)
in CDS
Who will pay if
Credit Spread > Standard Rate
Buyer (Protection Leg) pays Seller (premium leg)
What is the Recovery rate when CTD (Cheapest to deliver) is 45%
The recover rate will then be 45%
How to calculate payment of CDS?
Use your calculator
N = Number of years
PV = -CVA (negative value)
YTM = MRR
FV = 0
Solve for PMT
What does it mean when a CDS is trading at par?
It means there is no upfront payment.
PV Potection leg = Pv Premium leg
If a HY CDS is trading at par, and the spread is 4.3 %.
What option of trade would be sutible and why?
We belive that the rates will eventually converge.
From the perspective of the CDS, its premium is too high relative to the bond credit risk preimum.
From the perspective of the bond, the premium is too love relative to the CDS market, which means its price is too high.
Sell the bond at a profit if the spread goes from 4.3% to 5%.
Sell the protection via the CDS and profit id the spread decreases from 5% to 4.3%
Profit for Seller of protection formula
-(Change in spread) x Duration x Notional amount
If a HY CDS is trading at par, and the spread is 6.3 %.
The CDS is currently 20 BSP above par.
What option of trade would be sutible and why?
CDS trading at par means there is no upfront payment. Since the rates are equal to each other.
HY CDS is 5%, a CDS trading at par, plus 20 BSP implies the credit spread on the CDS is 5.2%
We beleive the rates will converge.
From the perspective of the CDS, the premium is too low relative to the bond credit risk premium.
From the perspective of the bondholder, the premium is too high relative to the CDS market, which means the price is too low.
Therefore we would buy the bond and profit from the spead, a decrease from 6,2% to 5.2% and we would buy the CFS and profit from the spread increase from 5.2% to 6.3%
