Credit Default Swap

INDEX
Credit Default Swap (CDS ) As product Credit Default Swap Structure CDS v/s Insurance Credit Event CDS A Hedging Tool CDS A Speculation Perspective Impact on CDS transaction - If Corp . B Defaults Settlement Procedures Example of Settlement Procedure Physical Delivery Cash Settlement Type of CDS Contracts (International Swap & Derivatives Association) - ISDA CDS Market Statistics CDS Valuation CDS Spread Calculation CDS Glossary ..............................................................3 ...............................................................4 5 6 ......7 8 ...9 ....10 .11 .12 .13 .14 15 .18 19 23 .24

Credit Default Swap (CDS) As Product

A Credit Default Swap is a bilateral agreement that allows one party to buy credit protection on a specified reference entity from another.

Two parties involved in CDS transaction are Protection Buyer and Protection Seller.

The protection buyer pays a periodic premium to the protection seller based on the notional principal, until any credit event happens.

If the reference obligation suffers a credit event , the seller makes a settlement payment to buyer.

Settlement is of two types cash (formulae based) or physical (exchange of assets).

After settlement CDS contract gets terminated and no future cash flows are booked on it.
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Credit Default Swap - Structure

Bonds (Reference Entity)

Premium Protection Buyer Credit Protection Contingent payment, if reference entity defaults, seller compensates buyer for loss Settlement Process Protection Seller

Cash

Physical

CDS v/s Insurance

Credit Default Swap is normally compared with the insurance contracts. In insurance contracts we used to pay the premium amount and get the loss amount recovered from insurance companies in case some damage happens to the asset insured. The concept is basically similar to the CDS Contracts. Still there are some key differences which distinguishes CDS contracts from Insurance contracts : A loss triggers an insurance payout and the contract continue, while as the credit event triggers the CDs contract gets terminated.

Insurance contracts are not traded in liquid markets.

The insured in an insurance contract must have an insurable interest, while CDS can be bought and sold where neither party have an interest in the underlying .

Credit Event
Any of the following reason can lead to a credit event : Bankruptcy Includes insolvency , appointment of administrators/ liquidators for creditors arrangement.

Restructuring Debt restructuring can be causing delay or reduction in interest payments , change in obligors seniority or a succession event.

Payment Default Payment failure on one or more obligations after expiration of any applicable grace period. Buyer is not able to recover the payment from reference entity.

Other Credit Events that can be added includes : - Rating downgrade below the agreed threshold . - Change in credit spread above agreed level.
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CDS a Hedging Tool

Bank has invested $10billion in bonds issued by Corp. A

Corp. A with BB
rating (reference entity)

Bank
Bank receives 10% interest from Corp. B

Bank will pay premium of 100bp on $10B

Provide credit protection, in case Corp. A defaults

Ins 1 with AAA

rating
Transaction between Bank and Ins1 is termed as CDS contract for $10B Notional principal. Corporate A act as a reference entity ,in case it defaults in making payment to Bank , Protection seller (Ins1) will compensate the Protection Buyer (Bank). Ins1 receives a periodic premium from Bank in exchange of credit protection provided by them.

CDS A Speculation Perspective

Bank has invested $10billion in bonds issued by Corp. A

Corp. A with BB
rating (reference entity)

Bank I
Bank receives 10% interest from Corp. B

Bank will pay premium of 100bp on $10B

Provide credit protection, in case Corp. A defaults

Bank II
(protection buyer)

Invested $2billion in bonds of Corp. B

Corp. B with BB
rating (reference entity)

Bank II receives 12% from Corp. B

Ins 1 with AAA

rating

H 1 (Protection Buyer)

Bank I and II has entered into a CDS contract with Ins 1 to mitigate the risk on there investments. However Hedge Fund (H1) asses that Corp. B will face a credit event in the near future, so he enters into CDs contract with Ins1 from speculation perspective, although he didnt hold the underlying asset. H1 will make payment of premium i.e. 200bp for $10B Notional amount. In case of default of Corp B, H1 will claim a loss of $10B from Ins1.

Impact on CDS Transaction - if Corp B defaults.

Consequences if Corp. B defaults : Ins 1 will make a payment of $2B to Bank II and CDS contract gets terminated.

Ins 1 will make payment of $10B to H1 . H1 as a speculator will have high gains from this transaction , as he only paid the premium of $200MM($10B X 2%) to earn $10B.
In the mean time Rating Agency (Moodys) realizes that Ins1 has been under capitalized , as they has to bear huge losses of $12B. As the financial performance of Ins1 is not up as per norms , so they de grade there credit rating from AAA to BB. As the credit rating of Ins 1 gets de graded , Bank I also feel that the credit protection they have taken for Corp A investments is no more safe , so they will wind up the contract with Ins 1 and look for another seller with better credit worthiness. Drawback in CDS Transaction : There are no legal requirements for Ins 1 to keep capital adequacy reserves for paying out Bank I and Bank II , in case any credit event triggers in future.
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Settlement Procedures
Physical Settlement : As credit event occurs , Settlement of CDs Contract is required. Most common method is physical delivery of reference asset to protection seller. Payment of par value is made by protection seller in exchange for the receipt of reference asset from protection buyer.

Protection Buyer Cash Settlement :

Reference Asset

Par Payment

Protection Seller

Protection seller makes payment in cash to protection buyer which is equivalent to Par
less post default market value.
Both counter parties normally wait for 2-4 weeks after credit event in order to establish the market value (recovery value).

Protection Buyer

Cash Payment

Protection Seller

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Example of Settlement Procedure

Bank ABC buys protection from Fund XYZ for reference obligation Reliance corporate Bonds

Notional Principal : $10 miliion

Term : 5 years

Premium : 620bp paid on quarterly basis.

Premium amount = 10X 6.20% = 0.62MM annually

Post credit event recovery rate is 55%.

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Physical Delivery
Situation I No Default 620,000 p.a.

Bank ABC

Fund XYZ

Situation II Credit Event Occurs

10,000,000

Bank ABC
$10MM face value of Reliance corporate Bonds

Fund XYZ

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Cash Settlement
Situation I No Default 620,000 p.a.

Bank ABC

Fund XYZ

Situation II Credit Event Occurs

4,500,000

Bank ABC

Fund XYZ

Cash Payment = 10,000,000 x (100-55)/100

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Type of CDS Contracts

Single Entity CDS : In this type of contract CDS has been taken to hedge for a single reference entity. This is most common type of Credit Default Swap. Basket Default Swap : A basket default swap is similar to a single entity default swap except that the underlying is a basket of entities rather than one s ingle entity. The swap could specify a portfolio of reference bonds and seller would have to make the contingent payment ,if any of these bonds experiences credit event. Usually the swap terminates as soon as the first credit event occurs. Loan Only CDS (LCDS) : This is conceptually similar to the standard CDS contract , but in this case underlying protection is sold on syndicated secured loans of reference entities only ,rather than on Bonds or any other asset.

Naked CDS : A CDS contract in which buyer does not own the underlying debt is referred to as naked CDS. This constitutes about 80% of CDS market. These are synthetic contracts and there is no limit for buying and selling these contracts. This short selling of CDs is a real threat for Capital Markets. This type of CDS are mainly used from speculation perspective.
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(International Swap & Derivatives Association) - ISDA

The International Swaps and Derivatives Association(ISDA) was founded in 1985 . Main role of ISDA is to make over-the-counter (OTC) derivatives markets safe and efficient. ISDA produced its first version of standardized CDS contract in 1999. ISDAs pioneering work is in developing the ISDA Master Agreement and a wide range of related documentation materials, and in ensuring the enforceability of their netting and collateral provisions , has helped to significantly reduce credit and legal risk. ISDA market agreement has been signed by both the counterparties while entering into the CDS contract and this agreement has been kept by ISDA for long , which helps in reducing the counterparty risk.

Today, the Association has more than 825 members from 57 countries on six continents. These members include a broad range of OTC derivatives market participants: global, international and regional banks, asset managers, energy and commodities firms, government and supranational entities, insurers and diversified financial institutions, corporations, law firms, exchanges , clearinghouses and other service providers.
ISDAs work in three key areas , reducing counterparty credit risk , increasing transparency, and improving the industrys operational infrastructure show the strong commitment of the Association toward its primary goals; to build robust, stable financial markets and a strong financial regulatory framework.
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(International Swap & Derivatives Association) - ISDA

Standardization of CDS Contracts has improved the transactional ease for CDS participants they can unwind the trade easily or enter into an offsetting contract with different counterparty . In addition single name CDS contracts matures on standard quarterly end dates . These two features has helped to promote liquidity and thereby stimulate growth of CDS market. Interesting Facts : Nearly 2/3rd of the top 6000 companies in the OECD(Organization for Economic Co-operation and Development) counties use OTC Derivatives to manage there risks. 6700 OTC credit default swaps trade daily. Of these, 4,900 are single-name reference entities and 1,800 are credit indices. 5 CDS indices make up 60% of the total daily CDS index trading volume. 13 out of 3,000 CDS single-names trades , 20 or more contracts per day. Which means 99% of single-name CDS contracts trade less than 20 contracts per day. According to recent survey data, 99 percent of eligible CDS transactions, and over 85 percent of eligible interest rate and equity transactions, are now confirmed electronically. The Association formed Determinations Committees to decide on issues such as credit events and implemented an auction process to assist with trade settlement. These initiatives enabled the OTC derivatives markets to handle over 60 credit events to date with no market disruption.

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(International Swap & Derivatives Association) - ISDA

ISDA and the industry are focused on reducing risk by encouraging greater use of central counterparty clearing facilities (CCPs) and by compressing or tearing up economically redundant trades .These efforts are working. The size of the CDS market has been reduced by more than 75 percent through a combination of clearing and compression.

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CDS Market Statistics

The typical maturity of a CDS is 5 years. The reference entity may be a corporate entity or a sovereign entity. In 1997, the notional open interest in CDS was on the order of 200 billion dollars, by 2007 it had grown to approximately USD 60 trillion. The volume of the CDS market has been reduced significantly since June 2008 due to CDS compression trades. According to a 2010 ISDA market survey, which monitors credit default swaps on single names and obligations, baskets and portfolios. (Trillion $) 2009 (Mid) 2009 $31.2 $30.4 $2.9

Notional Amount Outstanding Net Notional Amount Outstanding

2008 $38.6

Structure of cash flows in CDS is of credits and index trades, the notional amount outstanding of credit default swaps (CDS) was $30.4 trillion at the end of 2009, down 3 percent from $31.2 trillion at mid-year 2009. CDS notional outstanding for the whole of 2009 was down 21 percent from $ 38.6 trillion at the end of 2008. The $ 30.4 trillion notional amount was approximately evenly divided between bought and sold protection. Bought protection notional amount was approximately $ 15.4 trillion and sold protection was about $ 15.0 trillion, with a net bought notional amount of $ 451.3 billion.
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CDS Valuation
CDS Valuation is based on Discounted Present Value method. In this, Future Cash Outflows are discounted to evaluate the Present value of CDS Contract. Along with Discounted Cash Flows , probability of default and recovery are also considered while calculating the Present Value of CDS Contract.

Cash Outflow in Credit Default Swaps are divided into two parts :
Premium Leg : These are the periodic payments made by protection buyer to protection seller , until the maturity or termination of contract.

Contingent Leg : Contingent payments are originated by protection seller to protection buyer, in case credit event triggers. This is a difference between par and recovery value of the reference entity.

Premium Leg is also called as Fixed leg and contingent leg is also termed as Floating Leg.
Lets elaborate further with an example , A (Buyer) entered into a CDS contract with B (seller) for notional amount $100 of reference entity Corp Z. Deal spread as 200bp i.e. 2%. Premium = $100 X 2% = $2 . In the year 3, credit event triggers for Corp. Z and recovery rate is 40%. Contingent Payment made by B to A is ($100- 40% of $100 = $60) .

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CDS Valuation
Cash Flow - Premium Leg
2.5 2 1.5 1 0.5 Cash Flow Premium Leg

0
Year 1 Year 2 Year 3 Year 4 Year 5

Cash Flow - Contingent Leg

80 60 40 20 0 Year 1 Year 2 Year 3 Year 4 Year 5
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Cash Flow Contingent Leg

CDS Valuation
CDS Spread Calculations :

Illustration 1 : Notional Risk Free Rate Default Probability Recovery Rate $1000 5% 2% 40%

Credit Event triggers in the mid of year. Calculation of spread s for CDS.

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Payment of CDS Buyer - Fee Leg : Payment (If no Credit Event Triggers) Payment (If Ref. Entity Defaults) Expected Payment Expected Accrual Time Dis. Prob. Of PV of Notional PV of PV of PV Total PV of (in yrs) Factor Survival Payment Cash Flow Exp. Accrual Accrual Premium Leg T D P=(1-Def Pr) A=P*D N B=A*N C=E*0.50 D= C*N D+B 0.5 0.951 98% 0.932 1000 932.778 0.010 9.756 942.534 1 1.5 0.905 96% 0.869 1000 870.075 0.009 9.100 879.175 2 2.5 0.861 94% 0.810 1000 811.587 0.008 8.488 820.075 3 3.5 0.819 92% 0.755 1000 757.030 0.008 7.918 764.948 4 4.5 0.772 90% 0.704 1000 706.141 0.007 7.386 713.527 4.070 4,077.61 0.043 42.648 4,120.260 Pay off for CDS Seller Contingent Leg Time (in Yrs) T 0.5 1 1.5 2 2.5 3 3.5 4 4.5 Default Prob. D2 2.00% Dis. PV of Default Factor Prob. Dis E=D2*Dis 0.975 0.020 %age of Notional F=D2(1- Rec. Rate) 1.20% PV of Payoff G= Dis * F 0.012 Total PV of Contingent Leg G*N 11.707

1.96%
1.92% 1.88% 1.84%

0.928
0.882 0.839 0.799

0.018
0.017 0.016 0.015

1.18%
1.15% 1.13% 1.11%

0.011
0.010 0.009 0.009 0.051

10.920
10.186 9.501 8.863 51.178

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CDS Spread Calculation

Expected Pay off of Buyer : 4.070 + 0.43 = 4.11303 Expected Payoff of Seller : 0.051 For calculation of CDS spread we have to take an assumption that , PV of Fee Leg = PV of Contingent Leg. Spread for CDS Contract :

4.070s+0.43s = 0051 4.11303s = 0.051 s = 0.124

Deal Spread = 124bp Premium = Deal Spread X Notional Premium Amount = 1.24% X 1000 = $12.4
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CDS Glossary
Premium Premium paid by buyer to seller is expressed as Deal Spread multiplied by Notional Principal. Notional Principal Value of notional principal is based on reference entitys credit risk exposure. It has been used for arriving at premium payments and settlement payments. Reference Entity/ Credit The legal entity which has borrowed the money sovereign ,corporate or financial institutions. The default of reference credit triggers the contingent payout. Credit Event The event that occurs with respect to the reference entity the triggers the credit default swap payment. Spread The annual payments quoted in basis points paid annually. Payments are paid quarterly and accrue on an actual/360 day basis. Maturity The expiration of contract is usually on 20 th March, June , September or December.
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CDS Glossary

Default Probability Default probability is the likelihood of occurrence of default in CDS contract. Default probability is approximately equal to Spread/ (1- Recovery Rate).

Recovery Rate This is the rate of recovery on reference entity when credit event triggers. Conditional Probability Probability of default in a given period is conditional on not having been default up to that period. Like in the above illustration we have taken the assumption that Default will happen only in mid of the year. Due to this we have taken conditional probability to calculate the payoff for buyer. Gross Notional Values The sum of CDS contracts bought (or equivalently sold) for all Warehouse contracts in aggregate, by sector or for single reference entities displayed. Net Notional Values With respect to any single reference entity is the sum of the net protection bought by net buyers (or equivalently net protection sold by net sellers).

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CDS Glossary
For e.g. Citi Bank is the buyer of $10 million CDS contract from Bank Of America (BofA) on the Wal- Mart company and at the same time Citibank may be a seller of a $10 million CDS contract from Chase bank on Wal-Mart company. In this case, gross notional may be reported as 2 CDS contracts of $10 million each (for a total of $20 million) for Wal-Mart from the perspective of someone external to any of the specific details of the contracts, however, in reality, only a net amount of $10 million is actually at risk at any given time despite a reported gross figure of $20 million. If Wal-Mart goes bankrupt, Citibank will end up receiving $10 million from BofA and would also have to pay $10 million to Chase bank and would end up with no net profit or loss.

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