Reading 32: Credit Default Swaps Flashcards
Credit Default Swap
- 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
Notion Principal
-Face value of protection
Components of CDS
- 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
Coupon Rates
-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.
International Swaps and Derivatives Association
-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.
Single name CDS
- 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
Cheapest-to-deliver
-debt instrument with the same seniority as the reference obligation but that can be purchased and delivered at the lowest cost.
Index CDS
- 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
Default Types
- bankruptcy
- failure to pay
- restructuring
*Determination Committee declares when an event occurs.
CDS Settlement
-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)
Factors affecting CDS Pricing
-probability of default (or hazard rate)
PODt = PS(t-1) * hazard rate
-loss given default
-coupon rate on swap
CDS premium
CDS Spread = (1 - RR) * POD
Upfront payment (by protection buyer)
PV(protection leg) - PV(premium leg)
can approximate as:
CDS spread - CDS coupon rate
Upfront premium %
(CDS spread - CDS coupon) x duration = upfront premium%
CDS spread = (upfront premium %/duration) + CDS coupon
Price of CDS
$100 - upfront premium (%)
Profit protection buyer (%)
change in spread x duration x notional principal
*protection buyer is short credit-risk and benefits when credit spreads widen
Monetizing CDS
- enter in offsetting transaction
- Difference between upfront premium paid and received should be approx equal to the profit for the protection buyer.
Naked CDS
-investor with no underlying exposure purchases (or sells) protection in CDS market
Long/short trade
-investor purchases protection on one reference entity while simultaneously selling protection on another (often related) reference entity.
Curve Trade
- 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.
Basis Trade
-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.
Leveraged buyout trade
-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.
