Learning Module 5: Credit Default Swaps

EXAMPLE 1 Cheapest-to-Deliver Obligation 1. Assume that a company with several debt issues trading in the market files for bankruptcy (i.e., a credit event takes place). What is the cheapest-to-deliver obligation for a CDS contract where the reference bond is a five-year senior unsecured bond? A. A subordinated unsecured bond trading at 20% of par B. A five-year senior unsecured bond trading at 50% of par C. A two-year senior unsecured bond trading at 45% of par Solution: C is correct. The cheapest-to-deliver, or lowest-priced, instrument is the two-year senior unsecured bond trading at 45% of par. Although the bond in A trades at a lower dollar price, it is subordinated and, therefore, does not qualify for coverage under the CDS. Note that even though the CDS holder holds the five-year bonds, he will receive payment on the CDS based on the cheapest-to-deliver obligation, not the specific obligation he holds. EXAMPLE 2 Settlement Preference A French company files for bankruptcy, triggering various CDS contracts. It has two series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades at 40% of par. Investor X owns €10 million of Bond A and owns €10 million of CDS protection. Investor Y owns €10 million of Bond B and owns €10 million of CDS protection. 1. Determine the recovery rate for both CDS contracts. Solution: Bond A is the cheapest-to-deliver obligation, trading at 30% of par, so the recovery rate for both CDS contracts is 30%. 2. Explain whether Investor X would prefer to cash settle or physically settle her CDS contract or whether she is indifferent. Solution: Investor X has no preference between settlement methods. She can cash set- tle for €7 million [(130%) x €10 million] and sell her bond for €3 million, for total proceeds of €10 million. Alternatively, she can physically deliver her entire €10 million face amount of bonds to the counterparty in exchange for €10 million in cash. 3. Explain whether Investor Y would prefer to cash settle or physically settle his CDS contract or whether he is indifferent. Solution: Investor Y would prefer a cash settlement because he owns Bond B, which is worth more than the cheapest-to-deliver obligation. He will receive the same €7 million payout on his CDS contract but can sell Bond B for €4 million, for total proceeds of €11 million. If he were to physically settle his contract, he would receive only €10 million, the face amount of his bond. EXAMPLE 3 Hedging and Exposure Using Index CDS Assume that an investor sells $500 million of protection using the CDX IG index, which has 125 reference entities. Concerned about the creditworthiness of a few of the components, the investor hedges a portion of the credit risk in each. For Company A, he purchases $3 million of single-name CDS protection, and Company A subsequently defaults. 1. What is the investor's net notional exposure to Company A? Solution: The investor is long $4 million notional credit exposure ($500 million/125) through the index CDS and is short $3 million notional credit exposure through the single-name CDS. His net notional credit exposure is $1 million. 2. What proportion of his exposure to Company A has he hedged? Solution: He has hedged 75% of his exposure ($3 million out of $4 million). 3. What is the remaining notional on his index CDS trade? Solution: His index CDS has $496 million remaining notional credit exposure ($500 million original notional minus the $4 million notional related to Company A, which is no longer in the index). EXAMPLE 4 Hazard Rate and Probability of Survival Assume that a company's hazard rate is a constant 8% per year, or 2% per quarter. An investor sells five-year CDS protection on the company with the premiums paid quarterly over the next five years. 1. What is the probability of survival for the first quarter? Solution: The probability of survival for the first quarter is 98% (100% minus the 2% hazard rate). 2. What is the conditional probability of survival for the second quarter? Solution: The conditional probability of survival for the second quarter is also 98%, because the hazard rate is constant at 2%. In other words, conditional on the company having survived the first quarter, there is a 2% probability of default in the second quarter. 3. What is the probability of survival through the second quarter? Solution: The probability of survival through the second quarter is 96.04%. The probability of survival through the first quarter is 98%, and the conditional probability of survival through the second quarter is also 98%. The probability of survival through the second quarter is thus 98% x 98% 96.04%. Alternatively, 196.04% 3.96% is the probability of default sometime during the first two quarters.EXAMPLE 5 Change in Credit Curve A company's 5-year CDS trades at a credit spread of 300 bps, and its 10-year CDS trades at a credit spread of 500 bps 1. The company's 5 year spread is unchanged, but the 10-year spread widens by 100 bps. Describe the implication of this change in the credit carve. Solution: This change implies that although the company is not any riskier in the short term, its longer-term creditworthiness is less attractive. Perhaps the company has adequate liquidity for the time being, but after five years it must harin racing date se it will he generated to haze each false difficulting 2. The company's 10-year spread is unchanged, but the 5-year spread widens by 500 hps. Describe the implication of this change in the credit curve Solution: This change implies that the company's near-term credit risk is now much greater. In fact, the probability of default will decrease if the company can survive for the next five years. Perhaps the company has run into liquidity issues that must be resolved soon, and if not resolved, the company will default EXAMPLE 6 Premiums and Credit Spreads 1. Assume a high-yield company's 10-year credit spread is 600 bps and the duration of the CDS is 8 years. What is the approximate upfront premium required to buy 10-year CDS protection? Assume high-yield companies have 5% coupons on their CDS. Solution: To buy 10-year CDS protection, an investor would have to pay a 500 bp coupon plus the present value of the difference between that coupon and the current market spread (600 bps). In this case, the upfront premium would be approximately 100 hps (duration), or 8% of the notional 2. Imagine an investor sold five-year protection on an investment-grade company and had to pay a 2% upfront premium to the buyer of protection. Assume the duration of the CDS to be four years. What are the company's credit spreads and the price of the CDS per 100 par? Solution: The value of the upfront premium is equal to the premium -2%) divided by the duration (4), or 50 bps. The sign of the upfront premium is negative because the seller is paying the premium rather than receiving it. The credit spread is equal to the fixed coupon (100 bps) plus the upfront premium, amortized over the duration of the CDS (-50 bps), or 50 bps. As a remind er, because the company's credit spread is less than the fixed coupon, the protection seller must pay the upfront premium to the protection buyer. The price in currency would be 100 minus the upfront premium, but the latter is negative, so the price is 100(-2) 102 EXAMPLE 7 Profit and Loss from Change in Credit Spread An investor buys $10 million of five-year protection, and the CDS contract has a duration of four years. The company's credit spread was originally 500 bps and widens to 800 bps. 1. Does the investor (credit protection buyer) benefit or lose from the change in credit spread? Solution: The investor owns protection and is therefore short the credit exposure. As the credit spread widens (the credit quality of the underlying deteriorates), the value of the credit protection she owns increases. 2. Estimate the CDS price change and estimated profit to the investor. Solution: The percentage price change is estimated as the change in spread (300 bps) multiplied by the duration (4), or 12%. The profit to the investor is 12% times the notional ($10 million), or $1.2 million. EXAMPLE 8 Long/Short Trade with ESG Considerations Overview An analyst is evaluating two US apparel companies: Atelier and Trapp. Atelier is a large company that focuses on high-end apparel brands. It is profitable despite a high cost structure. Trapp is smaller and less profitable than Atelier. Trapp focuses on less expensive brands and strives to keep costs low. Both companies purchase their merchandise from suppliers all over the world. The analyst rec- ognizes that apparel companies must maintain adequate oversight over their suppliers to control the risks of reputational damage and inventory disruptions. Supplier issues are particularly relevant for Atelier and Trapp following a recent fire that occurred at the factory of Global Textiles, a major supplier to both com- panies. The fire resulted in multiple casualties and unfavorable news headlines. The analyst notices a significant difference in the way Atelier and Trapp approach ESG considerations. After the fire at its supplier, Atelier signed an "Accord on Fire and Building Safety," which is a legally binding agreement between global apparel manufacturers, retailers, and trade unions in the country where the fire occurred. After signing the accord, Atelier made a concerted effort to fix and enhance machinery in factories of its suppliers. Its objective was to improve workplace safety-notably, to reduce lost employee time due to factory incidents and the rate of factory accidents and fatalities. Investors view Atelier's corporate governance system favorably because man- agement interests and stakeholder interests are strongly aligned. Atelier's board of directors includes a high percentage of independent directors and is notably diverse. In contrast, Trapp's founder is the majority owner of the company and serves as CEO and chairman of the board of directors. Furthermore, Trapp's board is composed mainly of individuals who have minimal industry expertise. As a consequence. Trapp's board was unprepared to adequately respond to the Global Textiles fire. Given the lack of independence and expertise of Trapp's board, investors consider Trapp's corporate governance system to be poor. Because of its emphasis on low costs and reflecting its less experienced board. Trapp chose not to sign the accord. Implications for CDS Single-name CDS on both Atelier and Trapp are actively traded in the market. although Trapp's CDS is less liquid. Before the Global Textiles fire, five-year CDS for Trapp traded at a spread of 250 bps, compared to a spread of 150 bps for the five-year CDS for Atelier. The difference in spreads reflects Trapp's lower trading liquidity, perceived lower creditworthiness (primarily reflecting its smaller size and lower profitability), and hence higher default risk relative to Atelier. After the Global Textiles fire, spreads on the CDS for all companies in the apparel sector widened considerably. Credit spreads for the five-year CDS on Atelier widened by 60 hps (to 210 bps), and credit spreads for the five-year CDS on Trapp widened by 75 bps (to 325 bps). The analyst believes that over the longer term, the implications of the fire at Global Textiles will be even more adverse for Trapp relative to Atelier. The analyst's view largely reflects Trapp's higher ESG-related risks, especially the perceived weaker safety in its factories and its weaker corporate governance system. In particular, the analyst believes that spreads of Trapp's CDS will remain wider than their pre-fire level of 250 bps, but Atelier's CDS spreads will return to their pre-fire level of 150 bps. 1. Describe how the analyst can use CDS to exploit the potential opportunity. Solution The analyst can try to exploit the potential opportunity by buying protection (shorting the credit) on Trapp using five-year CDS and selling protection (going long the credit) on Atelier using five-year CDS. This trade would reflect both the anticipated continuing adverse spreads for Trapp relative to the pre-fire level and the return of spreads for Atelier to their lower pre-fire levels. For example, assume Atelier's five-year CDS spread returns to 150 bps from 210 bps, but Trapp's five-year CDS spread narrows to just 300 bps from 325 bps. The difference in spreads between the two companies' CDS would have widened from 115 bps (325 bps-210 bps) right after the factory fire occurred to 150 bps (300 bps-150 bps). This 35 bp difference in spread would represent profit (excluding trading costs) to the analyst from the long/short trade. EXAMPLE 9 Curve Trading An investor owns some intermediate-term bonds issued by a company and has become concerned about the risk of a near-term default, although he is not very concerned about a default in the long term. The company's two-year CDS currently trades at 350 hps, and the four-year CDS is at 600 bps. 1. Describe a potential curve trade that the investor could use to hedge the default risk Solution: The investor anticipates a flattening credit curve for the reference company, with spreads rising at the shorter end of the curve. Thus, he would buy credit protection on the two year (buy the two-year single-name CDS) while selling credit protection further out on the curve (sell the four-year single-name CDS). 2. Explain why an investor may prefer to use a curve trade as a hedge against the company's default risk rather than simply buying protection on the ref erence entity. Solution: The long/short trade reduces the cost of buying near-term credit protection, with the cost of the credit protection offset by the premium received from selling protection further out on the curve. This works only as long as the in- visitor's expectations about the relative risk of near-and longer-term default hold true EXAMPLE 10 Bonds vs. Credit Default Swaps An investor wants to be long the credit risk of a given company. The company's bond currently yields 6% and matures in five years. A comparable five-year CDS contract has a credit spread of 3.25%. The investor can borrow at MRR, which is currently 2.5%. 1. Calculate the bond's credit spread. Solution: The bond's credit spread is equal to the yield (6%) minus the market refer ence rate (2.5%). Therefore, the bond's credit spread is currently 3.5% 2. Identify a basis trade that would exploit the current situation Solution: The bond and CDS markets imply different credit spreads. Credit risk is cheap in the CDS market (3.25%) relative to the bond market (3.5%). The investor should buy protection in the CDS market at 3.25% and go long the bond, with its 3.5% credit spread, netting 25 hps. EXAMPLE 11 Using CDS to Trade on a Leveraged Buyout An investor believes that a company will undergo a leveraged buyout (LBO) transaction, whereby it will issue large amounts of debt and use the proceeds to repurchase all of the publicly traded equity, leaving the company owned by management and a few insiders. 1. Why might the CDS spread change? Solution: Taking on the additional debt will almost surely increase the probability of default, thereby increasing the CDS spread. 2. What equity-versus-credit trade might an investor execute in anticipation of such a corporate action? Solution: The investor might consider buying the stock and buying credit protection. Both legs will profit if the LBO occurs because the stock price will rise as the company repurchases all outstanding equity and the CDS price will rise as its spread widens to reflect the increased probability of default.