Credit Derivatives: Introduction to Credit Default Swaps

Question 1

What is a CDS spread?

Answer 1

Preimum paid by the protection buyer to the protection seller

Question 2

What is the reference entity?

Answer 2

Company or country subject to the credit event.

Question 3

What is a credit event?

Answer 3

Bankruptcy, failure to pay, restructuring

Question 4

What is physical settlement?

Answer 4

Delivery of the physical bond if credit event occurs.

Question 5

What is cash settlement?

Answer 5

Cash payoff equal to Notional x (1-R) if credit event occurs

Question 6

What is the recovery rate (R)?

Answer 6

Price % of the CTD bond resulting fomr an ISDA auction

Question 7

What are some basic CDS conventions?

Answer 7

• A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association (ISDA)
• The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling on March 20, June 20, September 20, and December 20
• Standard CDS contracts specify deliverable obligation cahracteristic: limitations include bonds or loans with maximum maturity of 30 years, unsubordinated, free from any transfer restrictions and contingency before due, expressed in standard currency
• Usually, a credit event includes failure to make a payment as it becomes due, bankruptcy or restructuring of debt

Question 8

What is the general procedure for calculating the fair spread for a CDS with simplified assumptions?

Answer 8

1. Estimate default and survival probabilities
2. Determine present values of expected payoff and expected Spread payment (spread payment is a formula from which we will calculate s: the spread)
3. We calculate the fair CDS spread by equating the PV of expected payoff and the PV of the expected spread payment
   Formula for PV of expected spread payment:
   s * survival probability (e^{-lambda bar* t})* e^{-r * t}
   and Formula for PV of expected payoff is:
   Notional * (1 - Recovery Rate) * Uncoditional probability of default (1-Survival Probability) * e^{-r * t}

Question 9

What are CDS contracts mostly used for?

Answer 9

1. Investment: synthetic directional view (long or short position) taken on the credit risk of the reference entity
2. Hedging: Mitigate the credit risk arising from exposures to the reference entity

Question 10

What are the views of the CDS buyer and seller on the spread?

Answer 10

1. Protection buyer has a bearish view on a cds (would prefer a credit spread decrease)
2. Protection seller has a bullish view on a cds (would prefer a credit spread increase)

Question 11

What is CDS-Bond basis?

Answer 11

CDS-Bond basis = (CDS spread - Bond’s yield spread)
1. Positive basis: Investor could borrow at less than the risk-free rate by shorting bond and selling protection through CDS
2. Negative basis: Investor could earn more than the risk-free rate by buying the bond and buying the protection through CDS

In general basis is close to 0