Understanding Credit default swaps

Key concepts:
1. A CDS contract transfer the risk of loan default to a counterparty such
as insurance company or pension fund.
2. Borrower is called reference entity and Default is called credit event.
3. If default event occurs, protection buyer (Bank which gave loan) has the right
to sell the loan against whose default risk the insurance has been bought.
4. Default event may be bankruptcy, insolvency or receivership.
5. The payment that is contingent on the event may be defined in terms of the
price of reference obligation, such as a bond.
6. Specific loan against which default risk is protected is known as reference
obligation or reference assets and total value for which CDS contract is
made is known as notional principal.
7. A recovery rate is defined as value of the bond immediately after default as a
percent of face value.
8. Cash flows occur in two legs: (a) Protection buyer make stream of payment
(usually quarter, semiyearly or yearly) until end of CDS contract or happening
of default event known as premium lag. The size of these periodic
payments is determined from quoted default swap spread. Default swap
premium is quoted on bps and paid on total protection amount and (b) In
case no credit event occurs, protection seller does not pay any thing and in
case of happening of event protection seller will have to compensate the loss
by paying the difference in notional amount and market value of defaulted
bank credit.
9. CDS spread quote are typically made as bid-offer. For example, a bank may
quote 5 year CDS of borrower XYZ as bid 250 bps and offer 300 bps
meaning thereby that bank is ready to buy protection at 250 bps per year
and sell protection at 300 bps per year.
Example Case:
1. Protection buyer, Bank A, wants protection against credit event (default risk)
of firm XYZ
2. The notional principal (face value) on which protection sought for is Rs. 10
crores. ( Bank A may have other exposure to firm XYZ but it wants
protection only for Rs. 10 crores that it consider vulnerable.
3. The protection is required for 2 years. ( credit facilities may be for 5 years but
protection is taken for 2 years only)
4. The defaults spread is 300 bps over the risk free rate ( prime rate)
5. Bank A, Protection buyer, has to make quarterly payment to Bank B , the
protection seller.
Example Cash flows:
1. Quarterly payment would amount to Rs. 750,000 ( 10 crores*.03*.25)
2. Assume that a point T the loan to firm xyz suffers a credit event. At this point
cheapest to deliver assets of the firm XYZ has a recovery price of Rs. 60 per
share for Rs. 100 of face value.
3. Cash flows are as follows:
a. Bank A the protection buyer pays bank B Rs. 7.5 lakhs per quarter up
to the time of the credit event. If the credit event occurs say one
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month after the completion of the quarter then a proportionate amount

(Rs. 7.50/3) would additionally be paid.
b. Bank B, the protection seller, compensates Bank A for the loss on the
face value of the assets by paying Rs. 10 crores* 40% = Rs. 4 crores.
Case Exercise of credit default swap spread:
Estimate the credit default swap spread based on the following information:
(a) Risk free rate 8% per annum.
(b) PD of reference entity is assumed to be 3% at the end of the year with no
earlier default history
(c) Protection buyer seek protection for three years
(d) Recovery rate is 30%
(e) Assume payments are made annually, ignore dealers margin and
transaction cost and no arbitrage assumption i.e. two pv must be equal at
the beginning of the contract.
Discount factor at 8% are:
Year
0
1
2
3

Discount factor @ 8%
1.00
0.926
0.857
0.794

STEP I = Construct unconditional default probabilities and survival

probabilities over three years:
Time

P(probability of default)

Q (probability
default)

of

no

1
2
3
STEP II= Cash flow of protection buyer assuming risk free rate 8%
(Calculate present value of expected fee payment = f per annum)
Note that payments will be made by the protection buyer only in case of no
default.
Time

Expected fee
F*q

Discount
factor 8%

PV
of
expected fee
payment

1
2
3
Total
STEP III= Cash flow of protection seller in case of credit event
(Calculation of present value of expected pay off in case of default
Notional principal $1) Note we assume that the credit event will occur only
at the end of the year.

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Time

1-RR

Expected
pay off

Discount
factor
@8%

PV
of
expected
pay off in
case
of
default

1
2
3
Total
STEP IV= Equate the two PV in steps II and Step III and solve value of f
Case Exercise Solution:
Suppose that the risk-free rate 8% per annum and PD of a reference entity is
assumed to be 3% at the end of the year with no earlier default history and
protection buyer seek protection for 3 years. If recovery rate is 30%,
estimate the credit default swap spread. Assume payments are made
annually. Discount factor at 8% are:
Year
0
1
2
3

Discount factor @ 8%
1.000
0.926
0.857
0.794

STEP I = Construct unconditional default probabilities and survival

probabilities over three years:
Time

P(probability of default)

Q (probability of no
default)
1
0.0300
0.9700
2
0.0291
0.9409
3
0.0282
0.9126
STEP II= Cash flow of protection buyer assuming risk free rate 8%
(Calculate present value of expected fee payment = f per annum)
Note that payments will be made by the protection buyer only in case of no
default.
Time

Expected fee
F*q

Discount
factor 8%

1
2

0.9700
0.9409

0.9700f
0.9409f

0.926
0.857

0.9126

0.9126f

0.794

PV
of
expected fee
payment
0.8982f
0.8063f

0.7246f
Total 2.4291f
STEP III= Cash flow of protection seller in case of credit event
(Calculation of present value of expected pay off in case of default

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Notional principal $1) Note we assume that the credit event will occur only
at the end of the year.
Time

1
2
3

0.0300
0.0291
0.0282

1- RR

0.7
0.7
0.7

Expected
pay off

Discount
factor
@8%

0.021
0.020
0.020

0.926
0.857
0.794

PV
of
expected
pay off in
case
of
default
0.019
0.017
0.016
Total
=
0.52

STEP IV: Equate the two PV in steps II and Step III and solve value of f
2.42917f=0.052 or f=.0214 times the principal or 214 bps per year.

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