Credit Default Swaps

Question 1

(In regards to CDS) Short position of underlying

Answer 1

Deteriorating credit quality - Buyer of CDS

Question 2

(In regards to CDS) Long position of underlying

Answer 2

Improving Credit quality - Short CDS

Question 3

Seller of CDS

Answer 3

Improving credit quality - Long underlying

Question 4

Buyer of CDS

Answer 4

Worsening credit quality - Short underlying

Question 5

CDS Buyer

Answer 5

Short Position of underlying credit quality

Question 6

CDS Seller

Answer 6

Long Position

Question 7

What does the credit protection buyer do in CDS?

Answer 7

Premium leg of the CDS
Makes a series of payments (premiums) in exchange.

Question 8

What does the Credit protection seller do in CDS

Answer 8

Protection leg of CDS
Makes payment in the event of credit event

Question 9

Singel name CDS

Answer 9

A CDS on a specific borrower (Reference entity)

Question 10

Name the 3 different types of CDS

Answer 10

1. Single name
   2.Index
2. Tranche

Question 11

What is Physical Settlement of a CDS?

Answer 11

Holder of the bond sells to CDS seller at par

Question 12

What is Cash Settlement of a CDS?

Answer 12

Seller pays holder for losses

Swap seller -> Swap buyer
Par - Market value

Payout amount = Payout ratio x Notional amount

Question 13

CDS leg: Protection Leg

Answer 13

Seller pays buyer
Protection seller pays protection buyer if credit event occurs

Question 14

CDS leg: Premium Leg

Answer 14

Buyer pays seller
Protection buyer makes periodic payment to seller of protection

Question 15

What is the formula for upfront payment

Answer 15

PV Protection leg - PV of Premium leg

Question 16

PV Protection leg > PV of Premium leg

Answer 16

> 0

Protection Buyer pays seller

Question 17

PV Protection leg < PV of Premium leg

Answer 17

Protection seller pays Buyer

Question 18

Full formula for uprfont payment

Answer 18

PV Protection - PV premimum
(Spread - rate) x Duration
(Credit Spread - Fixed Coupon) x Duration

Question 19

Formula for Credit Spread

Answer 19

Upfront payment / Duration) + Fixed Coupon rate

Question 20

Formula for Profit for CDS Buyer

Answer 20

Change in Basis points x Duration x Notional amount

Question 21

% Change in CDS price

(Formula for Profit for CDS Buyer)

Answer 21

Change in basis points x Duration

Question 22

How is the payoff determine for CDS?

Answer 22

The cheapest to delivery

Regardless of TTM, always chose the bond with the lowest % value trading at par

Question 23

When credit quality of the reference rate improves, what will happen to the protection leg of a CDS

Answer 23

Protection leg gains value, since the credit spread will be less than the premium rate

Question 24

When credit quality of the reference rate deteriorates, what will happen

Answer 24

Premium leg gails value, the credit spread will be greater than the premium rate

Question 25

Rates for investment-grade company CDS rates

Answer 25

1%

Question 26

Rates for High-yield company CDS rates

Answer 26

5%

Question 27

What is Credit spread?

Answer 27

Credit spread is the difference between the yield (return) of two different debt instruments with the same maturity but different credit ratings.

Question 28

Name the 3 types of credit event

Answer 28

1. Bankrupcy
2. Failure to pay
3. Restrucutring (voluntary restructuring is not a credit event)

Question 29

in CDS
Who will pay if

Credit Spread < Standard Rate

Answer 29

Seller (premium leg) pays Buyer (Protection Leg)

Question 30

in CDS
Who will pay if

Credit Spread > Standard Rate

Answer 30

Buyer (Protection Leg) pays Seller (premium leg)