Credit Risk and Credit Default Swap Flashcards
What is credit risk?
The possibility that a counterparty in a financial contract will not fulfill their contractual obligations.
What types of credit-linked events are associated with credit risk?
- Changes in credit quality.
- Variations in credit spreads.
- Default events.
How can credit risk be measured?
- Credit ratings from independent rating agencies.
- Market premium – the excess required return on a firm’s bond over a government bond of the same maturity.
What is the recovery rate?
The proportion of a bad debt that can be recovered after default.
What is loss given default (LGD)?
\text{LGD} = 1 - \text{Recovery Rate}
What is a credit event?
An event that triggers a compensation payment, such as:
1. Bankruptcy or debt restructuring.
2. Failure to meet scheduled debt payments or covenants.
3. Credit rating downgrade.
Who is the protection buyer in a credit derivative?
The party purchasing protection against a credit event.
Who is the protection seller in a credit derivative?
The party that compensates the protection buyer if a credit event occurs.
What is a CDS?
A financial contract that allows investors to trade the credit risk of a company’s bonds.
What are key features of a CDS?
- The protection buyer does not need to hold the bonds.
- The bond issuer may not be aware of the contract.
- Buying protection is like shorting a company’s debt.
- Trading bonds is costly because they are illiquid, whereas CDS are more liquid.
- The protection seller does not require initial funding.
What payments does the CDS buyer make?
Periodic premiums until default or maturity.
What payment does the CDS seller make if default occurs?
The difference between the bond’s par value (100) and its market value at default time
What is a reference entity?
The company whose credit risk the CDS contract is written on (e.g., General Motors).
What is a reference issue?
The specific bond(s) of the reference entity the CDS contract is written on (e.g., GM senior unsecured bonds).
What is the notional size of a CDS contract?
The dollar amount the contract covers, typically $10 million.
What is the most common maturity for a CDS?
5 years.
What are credit events in a CDS?
Events that trigger payments from the protection seller to the protection buyer.
What are the settlement methods in a CDS?
How compensation is paid when a credit event occurs.
What is the CDS premium (spread)?
The annual fee (normally paid quarterly) that the buyer pays to the seller.
When is an up-front fee paid in a CDS?
For low credit quality reference entities.
Where are CDS mostly traded?
Over-the-counter (OTC) markets.
What are some key aspects of CDS trading?
- Finding counterparties individually.
- Insider trading exists in the CDS market.
- CDS premiums tend to jump before M&A announcements.
- Inter-dealer brokers help match buyers and sellers.
- Exchange listing of CDS started in March 2007.
What is counterparty risk in a CDS?
The risk that the protection seller may default.
What factors determine the impact of counterparty risk?
- The credit quality of the protection seller.
- The correlation between the reference asset and the protection seller.
