Credit Default Swaps - Reading 36

Question 1

What is a credit default swap?

Answer 1

Basically an insurance contract. If a credit event occur, the credit protection buyer gets compensated by the credit protection seller.

Question 2

In what side of a transaction is a protection seller is in relation to credit risk?

Answer 2

long credit risk

Question 3

In what side of a transaction is a protection buyer is in relation to credit risk?

Answer 3

short credit risk

Question 4

Does CDS provide protection against market-wide interest rate risk?

Answer 4

No

Question 5

Does CDS provide protection against the principal

Answer 5

Yes

Question 6

Does CDS provide protection against market-wide interest rate and principal risk?

Answer 6

No

Question 7

What is the standard fixed coupon for an investment grade?

Answer 7

1%

Question 8

What is the standard fixed coupon for a high yield?

Answer 8

5%

Question 9

How to calculate the amount paid outfront

Answer 9

PV(standardized coupon) - PV(credit spread)

Question 10

What is the unofficial governing body of derivatives?

Answer 10

ISDA

Question 11

What is single name CDS?

Answer 11

the reference obligation is the fixed-income security on which the swap is written, usually a senior unsecured obligation

Question 12

What is the Cheapest-to-Deliver method (CTD)?

Answer 12

debt instrument with the same seniority as the reference obligation but that can be purchased and delivered at the lower cost.

Question 13

What is an index CDS?

Answer 13

an index CDS covers multiple issuer allowing market participants to take an exposure to the credit risk of several companies simultaneously in the same way that stock index allow investors to take on an equity exposure to several companies at once

Question 14

What is the relation between correlation fo default among index constituents and CDS spread

Answer 14

higher and higher

Question 15

What is a credit event?

Answer 15

occurrence of default

Question 16

3 main common types of credit event?

Answer 16

1. Bankrupcy
2. Failure to pay
3. Restructuring

Question 17

Who declares the credit event

Answer 17

The determination committee

Question 18

How many members in the determination committee

Answer 18

15

Question 19

How many members require to vote to declare a credit event?

Answer 19

12

Question 20

How to calculate payout amount for a swap settled in cash?

Answer 20

payout amount= payout ratio x notional principal

where payout ratio = 1 - revory rate (%)

Question 21

3 factors that influence the pricing of CDS

Answer 21

1. Probability of Default
2. Loss given Default
3. Coupon rate on swap

Question 22

What is the probability of default

Answer 22

likelihood of default by the reference entity in a given year

Question 23

What usually happens with the probability of default over time

Answer 23

usually increases

Question 24

What is conditional probability of default

Answer 24

also known as hazard rate

the probability of default in any given year assumes no default has occurred in preceding years

Question 25

What is a loss give default

Answer 25

expected amount of loss in the event that a default occurs

Question 26

how is loss given default related to the recovery rate

Answer 26

inversely related

Question 27

How to calculate the expected loss

Answer 27

expected loss_t=hazard rate_t x loss give default_t

Question 28

how to calculate upfront premium

Answer 28

upfront premium ( by the protection buyer) = PV(protection leg) - PV(premium leg)

upfront premium (%) = (CDS spread - CDS coupon) x duration

duration of CDS

Question 29

How to quote the CDS price

Answer 29

$100 - upfront premium (%)

Question 30

What is the credit curve?

Answer 30

the credit curve is the relationship between credit spreads for different bonds issued by the same entity

Question 31

What is a naked CDS

Answer 31

when an investor with no underlying exposures purchases protection in the CDS market

Question 32

Long short trade CDS

Answer 32

an investor purchases protection on one reference entity while simultaneously selling protection on another reference entity

Question 33

Curve trade on CDS

Answer 33

a type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity

Question 34

4 uses of CDS

Answer 34

• basis trade
• LBO’s
• credit risk of constituents is priced differently than the index CDS spread
• priced differently than the index CDS
• CDO (strips and straps)