Reading 56 - Credit Default Swaps Flashcards
In simple terms, what is a credit default swap?
An insurance contract. If a credit event occurs, the credit protection buyer gets compensated by the credit protection seller.
What is the ISDA?
International Swaps and Derivatives Association..
- Unofficial governing body of the industry
In the case of a single name CDS, what is the reference obligation?
The reference security on which the swap is written.
When does a CDS pay off?
- 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
How is the CDS payoff made?
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
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?
- Can’t select Bond P, not a senior bond
payoff = $10 million - (0.25)($10 million)
= $7.5 million
What is an index cds ?
covers multiple issuers, allowing market participants to take on an exposure to the credit risk of several companies simultaneously.
What are the common types of credit events specified in CDS agreements?
- Bankruptcy
- Failure to pay
- Restructuring
How many of the 15 ISDA members need to agree for a credit event to have occured?
A supermajority, 12.
What are the 3 factors that influence the pricing of a CDS?
- Probability of default
- Loss given default
- The coupon rate on the swap
Define what the Probability of Default is …..
The likelihood of default by the reference entity in a given year.
What is the hazard rate?
The probability of default given that it has not already occured.
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…
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%
Define what Loss given default is ….
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
What is the premium leg?
the payments made by the protection buyer to seller
What is the protection leg?
when the protection seller must make a payment to the protection buyer in case of a default.
How do you determine the upfront payment of a CDS??
This is paid by the protection buyer
** is the difference between the PV of the premium leg minus the PV of the protection leg
How do you calculate the upfront premium % of a CDS ?
** This is paid by the protection buyer.
= (CDS Spread - CDS Coupon) * duration of CDS
How can the quoted price of a CDS be calculated?
Price of CDS (per $100 notional) = $100 - upfront premium (%)
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….
How can the change in value of a CDS after inception be calculated?
What is a Naked CDS?
When an investor with no underlying exposure purchases protection in the CDS market.
Describe a Long/Short CDS trade…
An investor purchases protection on one reference entity while simultaneously selling protection on another (often related) reference entity.
What is a Curve trade?
A type of long/short trade where the investor is buying and selling protection on the same reference entity but with a different maturity.
What is a Basis Trade?
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
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:
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.
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?
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:
What is it called when an investor moves from off-the-run series to on-the-run series?
The move is referred to as a roll
What happes to the hazard rate when the credit spread widens??
It rises.
The entity is now more likely to default
The basis is _______ when the CDS spread is lower than the bond spread?
Also, what should be done to take advantage of this?
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)
The basis is _______ when the CDS spread is higher than the bond spread?
Also, what should be done to take advantage of this?
Positive
The investor should long the credit risk ( ie sell protection) and sell the bond short
