Reading 29: Credit Default Swaps

Page No. 97Date//Reading 29 : Credit Default SwapsIntroductionPromise to compensate in the event of defaltDefault Pay"Make periodic payn CCDS Spread)Economic Cos(redit Protection BuyerDealer(short)(credit protection seller)LongAlso protection against changes in market perception of borrower credit equity0If a credit event occurs ( the credit protection buyergets compensated by the credit protection seller0CDS does not Cover protection against market wideint rate risk, but only against credit risk.0(DS are written on debt of companies t debt ofsovereign local and state govt and on portfolios of loansof mortages CDS are similar to CDSReference obligation is a debt instrument issued by the0reference entityProtection buyer buyscredit protection from the protectionseller and paysCDS spread for the coverageofCDS does not eliminates credit Erisk it just substituesit with credit risk of seller Liability covered is not only the reference obligation but aslo all oth or98debt obligation that is lonked pari passu or higher relative to reference age No.obligation covered.Date / /Obligation & RisksProtection buyer is short credit risk & is obligation tomake CDS spread pay" - Short CDSProtection seller is long credit risk & is obligatied tomake a payn if a credit event occurs. Long CDSIIA CDS on a single specific borrower is called aSingle name CDS0Payoff on single-name CDS is based on the cheapest -todeliver (CTD) obligation with the same sensority.Single -Name CDS0CDS on specific borrowerBorrower is called reference entitityDDebt instrumentis called reference obligationReference obligation is not only the debt convered butalsothe debt that is pari passu or higher relative to thereference , obligation0Payoff is determined by cheapest -to -deliver obligationExample : Cheapest - to deliverParty X is a protection buyer in a $10 million notional principalsenior CDS of alpha Inc. There is a credit event Cie Alphadefaults) & the market price of Alpha's bonds after thecredit event are as followsShould be of some Rankmaterity mismatch is okay NP Protecti onReference oblignBuy!bondX4Page No. 99(investor)(issue ofbonds)Reference entityDate//(gos2onprotection sellerD Bend P, a subordinated unsecured debenture 7 is trading at 15% of parBood Q, a 5 -yr Senior unsecured debenture, is trading at 25% of par0 Bond R, a 3-yr senior unsecured debenture is trading at 30% of parWhat will be the payoff on the CDSSol" Reference obligation is a senior debEcture(TD with same seniority is bond Q (trading at 25% of par)Payoff = $10m - (0.25) ($10)= $7.5mcorrelationcheaper premIndex CDSA CDS on an equity equally weighted! combination of borrowersis called an Index CDSCredit correlation is Imp factor in pricing of index CDSCovers multiple issuers allowing market participants totothecreditrisk of severaltakeonanexposureCompanies simultaneously correlation of defaultprice for CDSThe protection for each issuer is equallovers a combination of borrowersInvestors can trade indexes of CDSHigher the cosselation of defaults, higherthe price of CDSNotes: The higher the correlation of default amoung index index CDSconstituents, the higher the spread on the Sell 250m of protection on CDX-16Buy Im protection on a xyz Co in the indexNet exposule to xzy?Im expore to x42Page No. 1005017250Date / /125No. ofIndexDescriptionEntitiesCDX - IGNorth-America - Investment Grade125CDX - HYNorth America High yield100iTraxx MainEurope, Asia, Austrialia - Invest Grade125.iTraxx CrossoverEurope Asia, Austrial - High yieldup to 50CDS SpreadsIG - Couted in terms of spreadiHy - quoted in terms of price0Standardization in CDS market makes CDS coupon # CDSspreadCouponStandardized by ISDA1% Invest" grade 1G5% High fieldHY0 Hence, an upfront pay is made by one of theCounterparties to the CDS ; this is called an upfrontprem.MCredit Protection Buyer - ShortpositionincreditRiskTranche CDSCredit protection Seller - longCovers a combination of borrowers but only up to apre - specified levels of lossesFeatures of CDS markets -Each CDS has a Notional amtCredit protection buyer does not have to own the reference doligeIndustry convention is to use a standard coupon rate(1% or 5%) as against credit spreadDiff b/w coupon rate & 1-10 credit spread is adjustedupfront prem Maturity 41 ) Syr most Commonusing XYZdefaults&totrade5at25%ofParPaq off = 250 125(25%) = 1.5 - Pay off on cdsPage No. 1015thNov23MondayAfterDate/defuntCDScontinuewith(25078ISDA CreditEventsof notionalBankruptcy:-Compliance : Sign an ISDA muster agreementPrincipalReyA benchmark protection filling allows thedefaulting party to work with creditors under theSupervision of the Court so as to avoid full liquidation.Failure to pay:-Occurs when the issuer misses a scheduledCoupon or principal pay" without filing formal bunkruptcyNot in usRestructuring:-Occurs when the issue forces the creditorstoaccept terms that are different than those specifiedin the original issue.Credit event :- It is an outcome that trigger the payKCDS sellerfromto CDS buyer0 Determinations :- Determines whether a credit event orCommitteeSuccession event has occured. 15-member group ISDAAsupermajority vote( ot least 12) is rey for u credit event toCDSSettlementaftercrediteventbedeclaredPhysical settlements or Cash settlement Recovery latePayoutamt=NotionalamtXPayoutratiooflossrecoveredPayout ratio = I - Recovery rate Page No. 102Date//Protection seller receives the RO & pays the protectionbuyer the notional amountPhysical Settlement on Credit Default swapswapReference obligationSwapSellerPar valueBuyerCash Settlement on Credit Default SwapSwapSwapsellerPar value - Market valueBuyerPayout amtDeterminants of CDS SpreadProbability of default is the likelihood of default inany given year by the reference entity POT over long PeriodConditional probability of default or hazard rute is theprobability occured of default given that no prior default hasLoss given default is the expected amount of loss inthe event a default occursExpected loss, b = Mazard Rate X Loss given defaultHR x LGDAll in fluences the pricing of CDS NewregulationsreqthattheantIallCDSbe Centrally clearedParlieswillsendtheircontractsthroughthatCollectanddistributeclearninghassesPage No. 103payn&ImposemarginDate//reqFactorsaffectingCDSPricing0CDS SpreadPDT & LGDDPDusuallyincreasesover timePD given that it hasA CreditRiskyofRoLHazardnot already occurred& of protectionCostRate0 LGDRecovery Rate(conditional probability of defect0Expectedloss=Hazard RateLGDto0Premium Legpay" made by protection buyerprotection sellerProtection LeyPaymadebysellerintheeventofdefaultProfits for=AindurationnotionalProtectionEng Spread Credit - Beg spred CreditprincipalBuyerspleueNote :- BuyerisshortcreditriskoffthusprofitswhenthecreditspreadwidensprocessfromanintheCDSvalue-*TheofcapuringmoneyexposureiscalledmonetizingthegainUprontPremcredit spread+CouponDulation Page No.104seller toDate / /TBuyerExpected coupon pay"Upfront Paymentmade by protection buyer0Upfront Payment = PV (Protection leg) - PV(Premium leg)from protection buyer)expected CF paid byprotection seller Cupon default)0Upfront Prem % nz (CDS spread - CDS coupon) X durationMeasure of timefrom protection buyer100 (+) forCoupon Pay v.s Credit Spread1% or 5%YTMPiem bond0Price of CDS 22$100Coupon YTMupfront prem (%)per $100 notional100 (x) fordisc bondCoupon < YTMProfits on CDS after InceptionspreadDProfit for Protection 2 Change in spread X Duration X Notional principalBuyer(in bps)exersise ofaffectsMonetizingthegains(losses)ofaCDSexposuremeanstocupturethe gains Closses) on a existing in-the-money -Cout- of money) CDSCanbedoneby understan undertaking an offsetting transactionExample : DS Pricing / valuationAki mutaro bond portfolio manager for aregional bank is buyingprotection on $10 million par value alp haInc.bonds t 10-yr CDS onAlpha Inc. bonds have a coupon rate of5%while 10-yr alphaCDS spread is 3.5% . The duration of the CDS is7.uTM Page No 105SDate / /-Calculate the approximate upfornt prem in %if the CDS Spread changes to 3% after inception (durationchange to 5.5) , Calculatetheprofit / Losson the bank 'sCDS exposure100 + (-10.5%)Price = 84.5sol"Upfront Prem % = (CDS spread - CDS Coupon) X duration= (3.5 $ (5) +7old new= -10.5%If the CDS spread changes to 3% after inception :Profit for protection buyer 2 Change in spread X durationXnotionalprincipal(+0.005X5.5xlom= + $275,000The bank would incur a loss of $275,000duetothenarrowingoftheCDSSpreadExample :- FV : 1,000Maturity : 2 yrCoupon 6%Recoveryrate:30%Hazard rates : Yr l 3% 41 2 = 47.Year / $6096%Yearz ; $ 106097%.604c.Year 1: $60Year 2 : 1060 X 30% = $3183,Prob of defeutYear : 60 X 30% = $184 1st yr(oc)G981 X4% 2nd yr Year 2: 1060 X 30% = $318&Psub of Survival3%(+)98% X47No defalt in 1st 41 & Nodefaut in zudyr3+3.88197% X 96%2 6-88= 93.12% Credit Carve :- Credit spread for a largeofmaturitiesofaComimpanydebtMAYup it credit curve541 cds spread =3%Page No. 106PD10-45cds -11- 55%Date//MaturityUpwaid slipingDownwaid slopper6 Probabilities of defaults : 3%&97% X 47. = 3-88%Lossgivendefault:(1060x70%)+(60x70%)=$ 784or1060 X 70% = $ 7462Expected loss : Loss given default X probability of default(3%) 284 + 3.88 x 742)= $52.310fUses of CDSManage credit exposureDInExploiting Valuation Disparitiesanticipationofdeclining(increase)creditspreads,aninvestmayincrease(decrease)Creditexposurebyselling(buying)protectionNaked CDS :- An investor with no underlying exposure buyerPCDS protection (bets on default)Buy CDS of one entity & Sell CDS of other entity (two entities might be rehaledLong/Short :- An investor purchases protection one onesomeLtradereference entity while selling protection on anotherInvestor is betting that the diff in credit spreadLong termwill change to the investor's advantageMore credit RiskCurve trade:-Along / shorttradeandwhere the Investor is buyingsellingprotectiononthesameCreditbutwithreferencelong CDS entityariskBuy CDS shot CDSdiff maturity.productivesell Ocos protectorCDSLorgosRisk increaseElikBuy COSNoRisk delinefitshortfsell PTD stelling (1)551.8PsitIIE marusitymaturity CDU - MF of varitity of diff debt security10 - Assem bling debt securities and issuiry claims Page No. lozguinst those Bolios in the form of tranches Date//An investors that expects an upward sloping credit curve tofletten should buy protection in a short maturity CDS&sell protection in a long - maturity CDSHCurve steepening FradeAninvestorwhobelievesthattheshort-term outlook isbetter than the long-term outlook Can use a curve -steepingtrade ; goingshortalong termCDS & long a short-termCDSYTM =61.55 Total outflow NBT -6-5-5borrow @1.5%CDS spred 4.0"=0.5% Arbitloy JtBasis Trade : Expoliting credit spread diff bet the bond marketrand CDS market.Another transaction - Buy and sell debt of the same entitybased on which the CDS market suggests to be over-or under pricedBondyield = RfR + Funding s pread t (readit speedIn a leverage buy outfilmwillissue debt to purchase StockthatwilltheCDSSpread CIBOR = RFR t Funding spreadCredit spied = Yield - LIBORSynthetic CDOs Constructed using CDS ( rather than actualbond as in a cash (DO)If a synthethic CDO Can be creadit at a cost lowerthan a cash CDO f profit by buying the syntheticCDO and selling the Cash CDO$100BankRef assetCDSFace value recovery valuespreadtrigg el event occurCDOSepan Senior $30m1Distribution$100Junnior / Mezzaming $69mlIWaterfullTRcollatial YeildEquity $ lmI Page No. 108Date //Market characteristics of CDSoCDS are centrally cleared(Parties send their contracts to the clearninghouses that collectand distribute payn and impose margin requirementsChanges In price of CDS provide an opportunity to unwindthe position (monetizing a GLL)0Two ways to monetize a positionI2Exercise a CDS in response to a defaultEntering into an offsetting positionDCredit CurveRelationship bet" credit spread & maturities of Company's bondUpward sloping curve (steeping) : Greater likehood of default inlater yrDDownyoward sloping curve ( Hatting): Gleater likelihood of default isFlat Curve : Hazard rate is constant.earlier yrApplication of CDSUses of CDS: :-Managing credit exposureExploiting valuation disparitiesBond yield=RFR + Funding Spread + Credit SpreadHujostow Page No. 109Date/ /RFRtSpreadLIBORFunding=Collateralizeddebtobligations(CDO) :claimsagainstapurtfolioofdebt securitiesSynthethicCDO:-BuyingSecurities&defaultsellingCDSfreeAv910) Page No. 10Date Bench markVery ImpTimeSpot rateExampleI5721. int late o =25%2Corp bond, / Hazard rate312LGD => 30%FV = 1000 C=18%IForward RateOnly571-072yly1.123= 22.717.lyly=9.03%1.0721.05Coupon tz2Binomial tree)+180.Coupon21.116118037.4471.37.4411800976.8858.51.0511.6%5 %22.717. 961.61- 1180116.37.03%VNB1101.9D13.77%11801037.18tzotitzt3YrExposurePDLGDELDFPVELI1219.3$2%30%7.320.95246.4621134.71.46%30%6.670.87395.82311801.4230%6.740.71184.8317.62 - CVAExposure Yr 2 = [25% X858.5 + 50% x961.61] + [25% X 1037.18+180=1134.7Exposure Yr2= [976-8 x 50 x.] + [1101.9 x 50% ] + 180 = 12193Corp bond = VND - CVA = 1161.3 - 17.62coupon E2= 1143.71 Page No 111Date / /A rated Corpbond + par = $100C=3.25%annual =5spread =170bpsbechmarkyield (flat)2%implied (VA ?VNDCorp bond priceCVAYield2%3.7%spreadPrice105.89-97= 7.91Hazard - -5%2% Approx3yr C=4.2% t benchmarkyield=2.5%originallyLGD - 90%HR - 7%3.5Change toLGW - 50%Calculate% A creditspreadspreadauvoo23VND4.24.24.2100tValuation104.85103.27101.65100103.27101.65100+4.2+4.2+4.2Exposure amt107.97105.85104.2YrExpPOLGDELOFPVELPDLGDELDFPVELI107.475y2.140.982.097%40%50%3.7610.983.59105.854.75%40%20110.9611.96.51750%3.445 0.9613.3223104.24.52%40%1.8830.9421.736.05%.50%3.152 0.9422.92CVA5.73Revised CVA9.83Value of104.85104.85bond-5.73-9.839.9.1295.024.53%6.08=1.547.YTM2-033.58-71.54spread Page No. 112Date / /PD= 47FV=100Maturity 441benchmark yield =121LGD=50%2cbOUND2CVA3Cup bad value4YTM5credit spreado(YrEADPDLGDELDFPVELI711.78hi.50%14.20.8412.7127973.8450%15.30.7912.4038923-64%50%16.40.7118.70410003.54%50%17.60.6311-24fiCVA47.87VND @ to=1000/1.124=635.510CUA = 47-87Cun be ase with OF in CalcsforthisValue of Corp bond=VND - CVA= 635.51 DB - 47.87CPT= 587 64YTM = 14-21PV = 587.04 MN= Fv=1000DApprox credit spread = LGD PDN=50%X4XCOWE coursed use it for 6ipA2%bond valul"RealCreditspred=YTM - benchmarkYTM= credit spred + benchmar= 14-4--12= 2+ 12= 2.21= 14FV1000N = 4VIMILY=14LTPFromvalue+2ofCoiptbundweCanfindCVDPV A 592592 = 635.51 - CUAWA 635-51-592This is for fast &ApposA 43