Credit Default Swap FIN-545 Nargiza Ludgate Phuong Anh Nguyen What is a SWAP? l Swap is a derivative in which two counterparties agree to exchange a sequence of cash flows over a period in the future. l Swaps are usually used to hedge risks (ex. interest rate risk), or to speculate on changes in the underlying prices. l Swaps can be interest rate swaps, currency swaps, commodity swaps, equity swaps, and credit default swaps. Credit Default Swaps l A Credit Default Swap (CDS) is similar to an insurance contract, providing the buyer with protection against specific risks associated with defaults, bankruptcy or credit rating downgrades. Characteristics l CDS is the most widely traded credit derivative product. Typical term of CDS contract is 5 years (up to 10-year CDS). l CDS documentation is governed by the International Swaps and Derivatives Association (ISDA), which provides standardized definitions of credit default swap terms, including definitions of what constitutes a credit event. Mechanism l One party “sells” risk and the counterparty “buys” that risk. l The “seller” of credit risk - who also tends to own the underlying credit asset - pays a periodic fee to the risk “buyer”. l In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default. Transaction Diagram Risk Buyer or Risk seller or Source: Credit Derivatives and Synthetic Structures, John Wiley & Sons. 2001 Potential Benefits l In addition, to hedging event risk, the CDS provides the following benefits: l A short positioning vehicle that does not require an initial cash outlay. l Access to maturity exposures not available in the cash market. l Access to credit risk not available in the cash market due to a limited supply of the underlying bonds. l Investments in foreign credits without currency risk. l Ability to effectively ‘exit’ credit positions in periods of low liquidity. Quoting CDS l 5 year CDS for Ford Motor Company debt l Nominal amount = $10 million l 160 bp on April 27, 2004 l 5-year protection l How much will you pay for protection? l (0.0160 / 4) x 10,000,000 = $40,000 (every quarter as a premium for protection against company default) 1-year CDS Contract Premium payments Investor No default: Zero Bank Loss recovery Credit ($10 mln) Loan Borrower High-risk entity for default 1-year CDS Contract t=0 t=1 t=2 t=3 t=4 Effective date l Nominal amount = N l Premium = c l Quarterly payment = Nc/4 There are 5 possible outcomes in this CDS contract: l No default (4 premium payments are made by bank to investor until the maturity date) l Default occurs on t1, t2, t3, or t4 CDS Pricing l Assign probability to each five outcome l Calculate PV of payoff for each outcome l Determine the price of CDS l Determine premium “C” paid l PV of CDS = PV of five payoffs multiplied by their probability of occurrence l Recovery Rate = R l Probability = P1 [ no default at to + t1 ] 1 – P1 [ default at t1 ] Bank’s Perspective 1- P1 P1 N(1-R) 1- P2 Nc/4 N(1-R) P2 Nc/4 1- P3 Nc/4 Nc/4 N(1-R) P3 Nc/4 Nc/4 1- P4 Nc/4 Nc/4 Nc/4 N(1-R) P4 Nc/4 Nc/4 Nc/4 Nc/4 Nc/4 Nc/4 Nc/4 Calculation of PV, given discount factor of δ1 to δ4 Description Premium Payment PV Default Payment PV Probability Default at t1 0 N (1 – R) * δi (1 – P1) Default at t2 - Nc/4 * δi N (1 – R) * δ2 P1 (1 – P2) Default at t3 - Nc/4 * (δi + δ2) N (1 – R) * δ3 P1 P2 (1 – P3) Default at t4 - Nc/4 * (δi + δ2 + δ3) N (1 – R) * δ4 P1 P2 P3(1 – P4) No default - Nc/4 * (δi + δ2 + δ3 + δ4) 0 P1 x P2 x P3 x P4 Calculation of PV of CDS Present Value of Credit Default Swap = = (1 – P1) x N (1 – R) δi + P1 (1 – P2) x [N (1 – R) δ2 - Nc/4 δi] + P1 P2 (1 – P3) x [N (1 – R) δ3 - Nc/4 (δi + δ2)] + P1 P2 P3(1 – P4) x [N (1 – R) δ4 - Nc/4 (δi + δ2 + δ3)] – (P1 x P2 x P3 x P4) x [Nc/4 (δi + δ2 + δ3 + δ4)] Summary l Due to its protection nature CDS market represents over one-half of the global credit derivative market. l CDS allows a party who buys protection to trade and manage credit risks in much the same way as market risks.
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