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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
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.
After settlement CDS contract gets terminated and no future cash flows are booked on it.
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Premium Protection Buyer Credit Protection Contingent payment, if reference entity defaults, seller compensates buyer for loss Settlement Process Protection Seller
Cash
Physical
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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Corp. A with BB
rating (reference entity)
Bank
Bank receives 10% interest from Corp. B
Corp. A with BB
rating (reference entity)
Bank I
Bank receives 10% interest from Corp. B
Bank II
(protection buyer)
Corp. B with BB
rating (reference entity)
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.
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.
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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Term : 5 years
Physical Delivery
Situation I No Default 620,000 p.a.
Bank ABC
Fund XYZ
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
4,500,000
Bank ABC
Fund XYZ
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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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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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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
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 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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