Reading 56 - Credit Default Swaps

Question 1

In simple terms, what is a credit default swap?

Answer 1

An insurance contract. If a credit event occurs, the credit protection buyer gets compensated by the credit protection seller.

Question 2

What is the ISDA?

Answer 2

International Swaps and Derivatives Association..

• Unofficial governing body of the industry

Question 3

In the case of a single name CDS, what is the reference obligation?

Answer 3

The reference security on which the swap is written.

Question 4

When does a CDS pay off?

Answer 4

• When the reference entity defaults on the reference obligation
• When the reference entity defaults on another other pari passu (i.e. same rank) or higher

Question 5

How is the CDS payoff made?

Answer 5

Is based on the market value of the cheapest-to-deliver (CTD) bond that has the same seniority as the reference obligation.

Notional Value - Cheapest-to-deliver bond = payoff

Question 6

Party X is a protection buyer in a $10 million notional principal senior CDS of XYZ Corp.There is a credit event and XYZ defaults. The market values of XYZ’s bonds are as follows after the event.

• Bond P , a subordinated unsecured debenture, trading at 15% of par
• Bond Q, a 5 year senior unsecured debenture, trading at 25% of par
• Bond R, a 3 year senior unsecured debenture, trading at 30% of par

What will be the payoff on the CDS?

Answer 6

• Can’t select Bond P, not a senior bond

payoff = $10 million - (0.25)($10 million)

       = $7.5 million

Question 7

What is an index cds ?

Answer 7

covers multiple issuers, allowing market participants to take on an exposure to the credit risk of several companies simultaneously.

Question 8

What are the common types of credit events specified in CDS agreements?

Answer 8

1. Bankruptcy
2. Failure to pay
3. Restructuring

Question 9

How many of the 15 ISDA members need to agree for a credit event to have occured?

Answer 9

A supermajority, 12.

Question 10

What are the 3 factors that influence the pricing of a CDS?

Answer 10

1. Probability of default
2. Loss given default
3. The coupon rate on the swap

Question 11

Define what the Probability of Default is …..

Answer 11

The likelihood of default by the reference entity in a given year.

Question 12

What is the hazard rate?

Answer 12

The probability of default given that it has not already occured.

Question 13

Consider a 5 yr CDS on ABC corp. ABC’s hazard rate is 2% and increases 1% a year.

Compute the survival rate after 5 years…

Answer 13

Hazard rates are: 2%, 3%, 4%, 5%, 6%

Surival rate in 5 years = (1-0.02)(1-0.03)(1-0.04)(1-0.05)(1-0.06) = 0.815 = 81.5%

Question 14

Define what Loss given default is ….

Answer 14

The expected amount of loss in the event that a default occurs.

** Is inversely related to the recovery rate

expected loss = hazard rate * loss given default

Question 15

What is the premium leg?

Answer 15

the payments made by the protection buyer to seller

Question 16

What is the protection leg?

Answer 16

when the protection seller must make a payment to the protection buyer in case of a default.

Question 17

How do you determine the upfront payment of a CDS??

Answer 17

This is paid by the protection buyer

** is the difference between the PV of the premium leg minus the PV of the protection leg

Question 18

How do you calculate the upfront premium % of a CDS ?

Answer 18

** This is paid by the protection buyer.

= (CDS Spread - CDS Coupon) * duration of CDS

Question 19

How can the quoted price of a CDS be calculated?

Answer 19

Price of CDS (per $100 notional) = $100 - upfront premium (%)

Question 20

The ten yr CDS on Comcast bonds have a coupon rate of 5% while the 10 yr Comcast CDS spread is 3.5%. The duration of the CDS is 7

Calculate the approximate upfront premium and price of a 10 yr Comcast CDS….

Answer 20

Question 21

How can the change in value of a CDS after inception be calculated?

Answer 21

Question 22

What is a Naked CDS?

Answer 22

When an investor with no underlying exposure purchases protection in the CDS market.

Question 23

Describe a Long/Short CDS trade…

Answer 23

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

Question 24

What is a Curve trade?

Answer 24

A type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity.

Question 25

What is a **Basis Trade**?

Answer 25

Is an attempt to exploit the difference in credit spreads between bond markets and the CDS market. **Basis = CDS spread (premium) - Bond's credit spread**

Question 26

5-year, 5% Zillon Corp. bonds currently trade at $980 reflecting credit spread of 3%. A 5-year CDS for Zillon bonds has a coupon rate of 5%. The duration of the CDS = 4. The upfront payment made/received by the protection buyer on a $4 million notional CDS is closest to:

Answer 26

Upfront payment = (CDS spread − CDS coupon) × duration × notional principal = (0.03 − 0.05) × 4 × 4,000,000 = −$320,000 The protection buyer will receive an upfront premium of $320,000.

Question 27

Consider a fixed-rate semiannual-pay equity swap where the equity payments are the total return on a $1 million portfolio and the following information: 180-day LIBOR is 5.2% 360-day LIBOR is 5.5% Dividend yield on the portfolio = 1.2% What is the fixed rate on the swap?

Answer 27

Question 28

Consider a 1-year semiannual equity swap based on an index at 985 and a fixed rate of 4.4%. 90 days after the initiation of the swap, the index is at 982 and London Interbank Offered Rate (LIBOR) is 4.6% for 90 days and 4.8% for 270 days. The value of the swap to the equity payer, based on a $2 million notional value is closest to:

Answer 28

Question 29

What is it called when an investor moves from off-the-run series to on-the-run series?

Answer 29

The move is referred to as a **_roll_**

Question 30

What happes to the hazard rate when the credit spread widens??

Answer 30

It rises. The entity is now more likely to default

Question 31

The basis is _______ when the CDS spread is _lower_ than the bond spread? Also, what should be done to take advantage of this?

Answer 31

**Negative** This implies that the CDS premium is too low relative to the credit risk premium. The investor should buy the CDS (ie buy credit protection) and buy the bond (assuming credit risk)

Question 32

The **basis** is _______ when the CDS spread is _higher_ than the bond spread? Also, what should be done to take advantage of this?

Answer 32

**Positive** The investor should long the credit risk ( ie sell protection) and sell the bond short