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									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
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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)
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 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
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 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
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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
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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
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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
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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
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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
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