Credit Default Swaps - Reading 36 Flashcards
What is a credit default swap?
Basically an insurance contract. If a credit event occur, the credit protection buyer gets compensated by the credit protection seller.
In what side of a transaction is a protection seller is in relation to credit risk?
long credit risk
In what side of a transaction is a protection buyer is in relation to credit risk?
short credit risk
Does CDS provide protection against market-wide interest rate risk?
No
Does CDS provide protection against the principal
Yes
Does CDS provide protection against market-wide interest rate and principal risk?
No
What is the standard fixed coupon for an investment grade?
1%
What is the standard fixed coupon for a high yield?
5%
How to calculate the amount paid outfront
PV(standardized coupon) - PV(credit spread)
What is the unofficial governing body of derivatives?
ISDA
What is single name CDS?
the reference obligation is the fixed-income security on which the swap is written, usually a senior unsecured obligation
What is the Cheapest-to-Deliver method (CTD)?
debt instrument with the same seniority as the reference obligation but that can be purchased and delivered at the lower cost.
What is an index CDS?
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
What is the relation between correlation fo default among index constituents and CDS spread
higher and higher
What is a credit event?
occurrence of default
3 main common types of credit event?
- Bankrupcy
- Failure to pay
- Restructuring
Who declares the credit event
The determination committee
How many members in the determination committee
15
How many members require to vote to declare a credit event?
12
How to calculate payout amount for a swap settled in cash?
payout amount= payout ratio x notional principal
where payout ratio = 1 - revory rate (%)
3 factors that influence the pricing of CDS
- Probability of Default
- Loss given Default
- Coupon rate on swap
What is the probability of default
likelihood of default by the reference entity in a given year
What usually happens with the probability of default over time
usually increases
What is conditional probability of default
also known as hazard rate
the probability of default in any given year assumes no default has occurred in preceding years
What is a loss give default
expected amount of loss in the event that a default occurs
how is loss given default related to the recovery rate
inversely related
How to calculate the expected loss
expected loss_t=hazard rate_t x loss give default_t
how to calculate upfront premium
upfront premium ( by the protection buyer) = PV(protection leg) - PV(premium leg)
upfront premium (%) = (CDS spread - CDS coupon) x duration
duration of CDS
How to quote the CDS price
$100 - upfront premium (%)
What is the credit curve?
the credit curve is the relationship between credit spreads for different bonds issued by the same entity
What is a naked CDS
when an investor with no underlying exposures purchases protection in the CDS market
Long short trade CDS
an investor purchases protection on one reference entity while simultaneously selling protection on another reference entity
Curve trade on CDS
a type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity
4 uses of CDS
- 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)
