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Document Sample
Hedging EM Corporate and Sovereign Credit
Risks with CDS
IMS Morning Seminar 3 November 2010
Iljaas Abdoella, Credit Structuring London
Capital Market Sales
Credit Default Swap
Using Credit Derivatives as a Hedge or an Investment
Definition: A Credit Default Swap (“CDS”) is a derivative security that has a payoff which is
conditioned on the occurrence of a Credit Event. The Credit Event is defined with respect to
a Reference Entity (and credit assets issued by the Reference Entity – the Reference
Obligation). If the Credit Event has occurred, the default payment has to be made by one of
the counterparties.
Credit Event is defined as:
At inception
• Bankruptcy
Premium for covered
• Failure to pay Notional (spread) Protection
Buyer
• Obligation default, obligation acceleration*
In case of a Credit Event
• Repudiation/Moratorium*
Covered Notional
• Restructuring Protection
Buyer
Defaulted Reference
Obligations
*Applies only to Sovereigns
Capital Market Sales
The Credit Default Swap
Premium in bps p.a.
Protection Pretection
Buyer Seller
Credit default protection
Payment Flows
(Protection Seller)
100 100
75 Quarterly premium Credit event 75 Credit Event before maturity
50 50
25 25
0 0
-25 1 2 3 4 5 6 7 -25 1 2 3 4 5 6 7
-50 -50
-75 -75
Maturity
-100 -100 (100 – Recovery)
Capital Market Sales
Basic Instrument
The Building Blocks
Payment of Money
includes borrowed money plus derivative
contracts and general creditors
Derivative
contracts Borrowed Money
Includes Bonds, Loans, Letters
of Credit and Certificates
of Deposit
Bonds Loans
Standards:
Obligations: Borrowed Money
Credit Events: Bankruptcy, Failure to Pay, Restructuring
Deliverable Obligations: Bonds or Loans
Capital Market Sales
Credit Default Swap
How CDS are used
CDS used to hedge credit risk
– Pay CDS spread in exchange for repayment if the bond defaults
– Able to hedge all types of credit exposure (lease receivables etc)
CDS used to generate income, go long risk
– Collect CDS spread in exchange for obligation to pay upon default
– Possible to “invest” in a bond that is not traded through repackaging
CDS used to speculate on changes in market sentiment on an issuer’s credit quality
– Buy/sell protection with expectation the spread will widen/narrow, at which time the
investor will unwind and lock in the gain
Capital Market Sales
The evolution of the synthetic credit market
CDS have become more liquid than the underlying obligations
A few remarks regarding CDS:
High liquidity especially for 5y, 7y and 10y tenors
[20-March], [20-June], [20-September] and [20-December] as standard issue/settlement dates
Official ISDA standard definitions for CDS transactions (specifying Credit Event definitions,
Successors, Settlements, Payments, Schedules, etc)
The CDS industry has made continuous and significant efforts to improve both the
standardization and content of documentation, as reflected in the ISDA 1999 and 2003 master
documents, and more recently, the 2009 ‘Big Bang’ and ‘Small Bang’ protocols
Credit event auctions (CEA’s) provide the CDS market with a standardized and efficient way to
determine the price at which all CDS contracts for an individual reference entity can be fairly
settled when a credit event occurs
Transparency of traded prices through Bloomberg and Markit (enabling the creation of a market
place and consequent growth in trading volumes) whilst current developments pointing towards
central counterparty clearing in the near future
Underlying securities: mainly Sovereign and Corporate debt (both Investment Grade and High
Yield) and CDS on Credit indices
Capital Market Sales
The evolution of the synthetic credit market
Credit Derivatives vs. Cash Bonds
Cash Bonds Credit Derivatives
Available credits Limited to bond issuers Unlimited
Liquidity Mixed liquidity No maximum size
Maturities Fixed dates IMM dates, but any date possible
Short Position Depends on Repo Market Buy protection at fixed cost, in size
Investment Cash or Repo Unfunded (Swap) or Funded (Note)
Coupon Generally fixed Fixed or Floating (if repackaged)
Capital guarantee Very occasionally Possible
CDS offer relative value, access to a wider universe of credits and enormous structural flexibility
Capital Market Sales
CDS Valuation
PV protection leg = PV premium leg
Inputs:
Maturity Premium in bps p.a.
Probability of default Protection Pretection
Expected Recovery Buyer Seller
Credit default protection
Interest rates
Capital Market Sales
Selective Pricing on CDS
For example:
if client whishes to hedge a
3yr bond USD 30m on VTB
then client would buy
protection at 294 bps as
indicated on this screen.
The total payments per year
would be around 294 bp x
USD 30,000,000
= USD 882,000
Capital Market Sales
Reasons for repackaging
Traditional investors in repacked notes:
A diverse range of investors purchase repackaged notes including corporates, banks,
insurance, funds and retail
Generally, these investors have something in common: internal/external factors limit their ability
to source assets with the desired profile
Reasons behind repackaging:
Access to derivatives markets without requiring dedicated booking, risk management system
or ISDA documentation
Need for bonds with customized currency, notional, maturity, premium, or exposure
Capital Market Sales
Disclaimer
This document is intended for discussion purposes only and does not create any legally binding obligations on the part of Deutsche Bank AG and/or its affiliates
(“DB”). Without limitation, this document does not constitute an offer, an invitation to offer or a recommendation to enter into any transaction. When making an
investment decision, you should rely solely on the final documentation relating to the transaction and not the summary contained herein. DB is not acting as your
financial adviser or in any other fiduciary capacity with respect to this proposed transaction. The transaction's) or products) mentioned herein may not be appropriate
for all investors and before entering into any transaction you should take steps to ensure that you fully understand the transaction and have made an independent
assessment of the appropriateness of the transaction in the light of your own objectives and circumstances, including the possible risks and benefits of entering into
such transaction. For general information regarding the nature and risks of the proposed transaction and types of financial instruments please go to
www.globalmarkets.db.com/riskdisclosures. You should also consider seeking advice from your own advisers in making this assessment. If you decide to enter into
a transaction with DB, you do so in reliance on your own judgment. The information contained in this document is based on material we believe to be reliable;
however, we do not represent that it is accurate, current, complete, or error free. Assumptions, estimates and opinions contained in this document constitute our
judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions
and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. This material was prepared by a
Sales or Trading function within DB, and was not produced, reviewed or edited by the Research Department. Any opinions expressed herein may differ from the
opinions expressed by other DB departments including the Research Department. Sales and Trading functions are subject to additional potential conflicts of interest
which the Research Department does not face. DB may engage in transactions in a manner inconsistent with the views discussed herein. DB trades or may trade as
principal in the instruments (or related derivatives), and may have proprietary positions in the instruments (or related derivatives) discussed herein. DB may make a
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