Reading 32: Credit Default Swaps

Question 1

Credit Default Swap

Answer 1

• essentially and insurance contract
• if a credit event occurs, the credit protection buyer gets compensated by the credit protection seller.
• protection buyer pays seller a premium called the CDS SPREAD
• Protection seller is assuming (long) credit risk, while the buyer is short credit risk.
• delivered in cash or physical delivery

Question 2

Notion Principal

Answer 2

-Face value of protection

Question 3

Components of CDS

Answer 3

• Protection buyer: short credit risk or reference asset and short the CDS
• Protection seller: long the CDS and long the credit risk of reference asset

Question 4

Coupon Rates

Answer 4

-standardization has led to fixed coupon rates (1% for IG, 5% for HY)

EX:
CDS on IG bond with credit spread of 75bps would require a coupon payment of 1% by the protection buyer. This would lead to buyer paying too much. Seller would pay upfront to the buyer the PV of 25bps present value of notional principal.

Question 5

International Swaps and Derivatives Association

Answer 5

-unofficial governing boy of the industry, publishes standardized contract terms and conventions in the ISDA Master Agreement to facilitate smooth functioning of the CDS market.

Question 6

Single name CDS

Answer 6

• reference obligation is the fixed income security on which the swap is written, usually a senior unsecured obligation.
• The issuer is the reference entity
• When does it pay out: only when reference entity defaults on the reference obligation or when they default on any other issue that is ranked pari passu.
• Payout is based on market value cheapest-to-deliver method

EX
$10M notional principal, bond trading at 25% of par. Payout:

$10M - (0.25)($10M) = $7.5M

Question 7

Cheapest-to-deliver

Answer 7

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

Question 8

Index CDS

Answer 8

• covers multiple issuers, allowing market participants to take on an exposure to credit risk of several companies simultaneously in the same way stock indexes allow investors to take on an equity exposure to several companies at once.
• Protection for each issuer is equally weighted

Ex:

Party X is buyer in five-year, $100M notional principal CDS for CDX-IG, which contains 125 entities. One index constituents defaults and bond trades at 30% of par after default.

CDS payoff? $100M/125 = $0.8 per entity. Payout is $0.8Million - (0.3)($0.8M) = $560,000
Notional P after default? $99.2M

Question 9

Default Types

Answer 9

• bankruptcy
• failure to pay
• restructuring

*Determination Committee declares when an event occurs.

Question 10

CDS Settlement

Answer 10

-Physical

Swap seller gets reference obligation
Swap buyer gets par value

-Cash

Swap buyer gets payout amount = (payout ratio x notional principal) or (Par Value - Market Value)

Question 11

Factors affecting CDS Pricing

Answer 11

-probability of default (or hazard rate)
PODt = PS(t-1) * hazard rate
-loss given default
-coupon rate on swap

Question 12

CDS premium

Answer 12

CDS Spread = (1 - RR) * POD

Question 13

Upfront payment (by protection buyer)

Answer 13

PV(protection leg) - PV(premium leg)

can approximate as:

CDS spread - CDS coupon rate

Question 14

Upfront premium %

Answer 14

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

CDS spread = (upfront premium %/duration) + CDS coupon

Question 15

Price of CDS

Answer 15

$100 - upfront premium (%)

Question 16

Profit protection buyer (%)

Answer 16

change in spread x duration x notional principal

*protection buyer is short credit-risk and benefits when credit spreads widen

Question 17

Monetizing CDS

Answer 17

• enter in offsetting transaction

- Difference between upfront premium paid and received should be approx equal to the profit for the protection buyer.

Question 18

Naked CDS

Answer 18

-investor with no underlying exposure purchases (or sells) protection in CDS market

Question 19

Long/short trade

Answer 19

-investor purchases protection on one reference entity while simultaneously selling protection on another (often related) reference entity.

Question 20

Curve Trade

Answer 20

• investor buys and sells protection on same reference entity but with a different maturity.
• If an investor expects that an upward-sloping credit curve on a specific corporate issuer will flatten, she may take the position of protection buyer in a short-maturity CDS and the position of protection seller in a long maturity CDS.

Question 21

Basis Trade

Answer 21

-attempt to exploit the difference in credit spreads between bond markets and CDS markets

EX: specific bond is trading at a credit spread of 4% over LIBOR in the bond market, but the CDS spread on the same bond is 3%….a trader can profit by buying the bond and taking the protection buyer position in the CDS market. If convergence, occurs…trader will profit.

Question 22

Leveraged buyout trade

Answer 22

-firm must issue more debt to purchase all of equity, additional debt will increase CDS spread and an investor anticipating an LBO may buy the stock and the CDS protection, both of which will increase in value when the LBO eventually occurs.