HOFIS 66 - Credit Derivatives Flashcards
1
Q
Main component of a CDS contract
A
- Reference Bond: Specifies the bond whose credit event will result in the protection seller compensating the protection buyer.
-
Fixed coupon rate: determines the amount the protection buyer must pay to the protection seller for each period of protection.
- typically made every 6 months.
-
Length of CDS Contract: specifies the length of the protection of the CDS contract
- some of the most liquid tenors are 5 years, 7 years,and 10 years.
2
Q
Two ways a CDS can be settled when a credit event occurs
A
- Cash-settlement: protection seller pays the protection buyer the protection payment of “Par x (1 - Rec)” in cash
-
Physical-settlement:
- protection buyer chooses from a list of bonds that are similar to the reference bond
- deliver the bond to the protection seller
- receives the par value of the bond from the seller in return
- can increase the value of the protection payment for the buyer if he chooses CTD w/ prices less than “Par * Rec”
3
Q
List the CDS market participants and uses
A
- Net protection buyers
- Commercial banks: hedge credit risk of loans
- Corporations: hedge risk of future receivables
- Investment banks: similar to CB but tend to run balanced books
- Net protection sellers
- Insurance companies: extra source of yield to asset portfolio
- Hedge funds: market strategy
- Pension funds: steady source of premium income
4
Q
Pure Credit Play of CDS
A
CDS are liquid, transparent instruments that offer investors pure exposure to returns
related to credit in the market, with very little interest rate exposure
5
Q
Speculation on the credit quality of certain bonds using CDS
A
- CDS protection buyer does not need to own the reference bond.
- If a person believes a firm’s credit quality will deteriorate, buying protection on a CDS on that firm’s bond is a convenient instrument with little upfront cost to express this speculative viewpoint
6
Q
Uses of CDS in Structure credit investments
A
CDS can be used as building blocks for more complicated and exotic structured credit investments, such as synthetic CDOs.
7
Q
Credit Events of a CDS
A
- Bankruptcy: Corporation is insolvent and cannot pay its debt, thus causing the reference bond to default.
- Failure to Pay: The firm fails to make due payments, even after a grace period
- Obligation Acceleration: When obligations are required to be paid earlier because of default in other bonds the firm issued.
- Obligation Default: This is when obligations become due and are payable prior to maturity of the original bond.
- Repudiation/Moratorium: When the government or another reference entity rejects the validity of the bonds/obligations. This can often occur for sovereign credit when an international government is in crises.
- Restructuring: A soft credit event where the firm’s debt experiences credit detereoration, but the firm can still restructure its debt with the debtholders.
8
Q
On the Run CDX
A
- Most recent issue of a CDX
- Typically the most liquid one
- Consitutents might be different than firms that made up the previous issued CDX
9
Q
Similarities of CDS and CDS indices
A
- To enter into a CDX index, the buyer pays an upfront cost that is either positive or negative, depending on the size of the fixed coupon paid by the index.
- At issue, the CDX coupon is set to make the total upfront cost equal to 0.
- After issue, changes in the market perceived quality of the underlying components of the index will cause the upfront value of the CDX to change.
10
Q
Differences of CDS and CDS indices
A
- “Buying the index” refers to selling protection on a CDX Index and assuming credit risk.
- In contrast, in the CDS market, “buying the index” refers to purchasing protection.
- If one of the components of the CDX index experiences a credit event, then that component is removed from the CDX index and the premium and protection legs of the CDX index will be adjusted accordingly.
