Credit Default Swaps Flashcards
What is a credit default swap?
- financial contract that allows investors to transfer credit risk to a third party for a set period. The buyer of the CDS pays the seller a protection premium, and in return, the seller agrees to compensate the buyer if the underlying credit defaults.
What are the 2 key players in a credit default swap and functions?
- Credit protection buyer: Pays regular premiums and receives compensation if a credit event occurs.
- Credit protection seller: Receives premiums and promises to pay in case of a credit event.
What is a single name CDS?
- single-name credit default swap (CDS) is a derivative contract that transfers the credit risk of a specific borrower (the reference entity) from one party to another, with the buyer receiving compensation if the reference entity default. (Usually senior unsecured debt)
What is an index CDS?
- Covers a portfolio of reference obligations (a group of company’s rather than just 1) allowing exposure to multiple borrowers.
What are tranche CDS?
- tranche CDS covers a combination of borrowers and allows investors to limit the extent of the coverage to a pre-specified level.
What does the standard format ISDA master agreement cover?
- Notional amount – The size of protection (can be larger than the debt issued).
- Coverage period – Usually 1 to 10 years.
- CDS spread (premium(coupon)) – Paid by the buyer, similar to a bond’s credit spread. Standard is 1% for IG, 5% for high yield.
Who has long and short exposure in single CDS?
- Buyer = Short credit exposure (bets on credit worsening).
- Seller = Long credit exposure (bets on credit improving).
Who has long and short exposure in index CDS?
- Buyer = Long credit exposure.
- Seller = Short credit exposure.
What are the 3 types of credit events, and who determines if a credit event has occurred?
- Bankruptcy
- Failure to pay
- Restructuring
ISDA’s Declaration Committee makes the final decision on whether a credit event has occurred, and also makes decisions regarding succession events (e.g., mergers, divestitures, and spinoffs)
What are 2 ways CDS can be settled, and give an example of how the exchange would work?
cash or physical settlement.
physical settlement: The credit protection buyer delivers debt securities to the seller in exchange for their full face value.
cash settlement: The seller pays the buyer a cash amount based on the loss suffered (difference between debt value and recovery).
What is payout from CDS contract based on and formulas?
based on loss given default (LGD)
LGD = 1- recovery rate
Payout = LGD * notional amount
How are CDS indexes weighted and classified?
- Equally weighted: Each component in the index is equally weighted. For example, in an index of 100 components, a single bankruptcy triggers a 1% settlement.
- Classification: CDS indexes are often categorized by region and credit quality.
What is the goal with forward contracts?
- Forward Contracts: price of a forward contract should make investors indifferent between buying an asset at a future date and borrowing at the risk-free rate to buy the same asset today and hold it until the contract’s maturity.
What is the credit value adjustment?
- key to pricing a CDS contract is determining the credit value adjustment (CVA), which can be described as the present value of credit risk.
What is expected exposure, recovery rate, and probability of default in CVA? What is formula for probability of default for 3 quarts?
- Expected Exposure (EE): This is the value at risk in the event of default during a given period.
- Recovery Rate (RR): This is the percentage of exposure that is expected to be recovered in the event of default.
- Probability of Default (POD): This is the conditional probability of default in a given period, given that no default occurred in previous periods, also known as the hazard rate.
(1- POD)^N
What is expected loss vs PVEL in CVA?
- Expected Loss (EL): This is the probability-weighted value of expected losses in a given period. It is calculated as the product of LGD (in monetary terms) and the probability of default for the period.
- Present Value of Expected Loss (PVEL): This is the expected loss in a given period discounted at the risk-free rate.
What is loss given default and formula?
- Loss Given Default (LGD): This is the percentage of exposure that is expected to be unrecoverable in the event of default. In monetary terms,
LGD can be calculated as follows:
LGD = expected exposure (EE)* (1-recovery rate (RR)
What is probability of survival and formula?
- Probability of Survival (POS): This is the conditional probability that the issuer will not default in a given period, given that it didn’t default in previous periods.
Assuming a constant hazard rate (POD) each year, the probability of survival for Year N is calculated as follows:
Probability of survival (POS) = (1-probability of default (POD) ^N
What is protection leg vs premium leg?
- protection leg is the contingent payments that would be made by the protection seller if the credit event occurs
- premium leg is the series of periodic payments made by the protection buyer
What is formula for upfront payment for initiation of CDS? What is the upfront payment for?
upfront payment = PV of protection leg - PV of premium leg
- Upfront payment is to ensure contracts pricing is in line with credit risk.
- if credit spread is more than the standard coupon rate, the upfront payment is made from the protection buyer to the protection seller. If the spread is less, the credit protection seller pays an upfront premium to the party buying credit protection.
What is formula for approximating the CDS spread? What is the CDS spread?
- CDS spread: credit spread is the return in excess of a market reference rate that investors demand as compensation for taking on credit risk
CDS spread = loss given default * probability of default
What is formula for present value of credit spread?
PV of credit spread = upfront premium + PV of fixed coupon
What’s formula for upfront premium value, and formula for upfront premium percentage?
upfront premium value = (credit spread - fixed coupon) * CDS duration
upfront premium percentage = 100 - CDS price per 100 par
What are 3 reasons valuation changes for CDS during their life span and formula for percentage changes in CDS price?
- changes are driven by underlying factors such as duration, default probability, and expected loss given default.
% change in CDS price = change in spread bps * duration
What is a naked credit default swap position?
naked credit default swap position: party that has purchased credit protection without holding the reference obligation. party is betting that the reference entity’s credit quality will deteriorate.
What is long/short strategy in CDS?
- long/short trade: taking a long position in one CDS & short position in another. bets that one reference entity’s credit quality will improve relative to the other’s.
What is the curve trade CDS strategy?
- curve trade involves buying a CDS of one maturity and selling a CDS with a different maturity for the same reference entity. The investor is betting on credit curve changes.
What is basis trading for CDS?
- Basis trades: seeking to exploit differences in the credit spreads offered by the CDS market and the bond market
