Credit Derivatives are bilateral contracts for transferring credit risk from one party to another.
Protection buyers are Banks and Securities Houses hedging of credit portfolio and optimizing credit exposure. They hedge risk and are short risk.
Buyer pays a quarterly premium and delivers bond at par upon default.
Protection sellers are Insurance Companies and Funds gaining credit exposure for income. They take on risk and are long risk.
Seller receives periodic payments and must buy bond at par upon default.
Reference Entity business entity that trigger credit event
A credit event triggers a default, which leads to settlement of contract.
ISDA - International Swaps and Derivatives Association, Inc.
Purposes:
• Hedging credit exposure
• Incurring credit exposure without holding debt instrument
• Tailoring credit exposure beyond holding debt instrument
• Create leveraged instrument to enhance yield
• Separating risks embedded in securities
• Managing an institution’s regulatory or economic capital requirements
Credit Derivative market share breakdown:
Single Name CDS 45%
CDOs 22%
Credit-Linked Notes 8%
Total Return Swaps 7%
Asset Swaps 7%
Baskets 6%
Credit Spread Options 5%
Entity Types:
Corporates
Financials
Sovereigns
Ratings
AAA-AA 22%
A-BBB 67%
BB-B 11%
Maturities
< 1yr 7%
1 – < 5yrs 42%
5yrs 37%
> 5 - 10yrs 9%
> 10yrs 5%
Regions
London 54%
US 29%
Asia/Australia 8%
Europe 5%
Credit Events that trigger settlement:
Bankruptcy - insolvency
Failure to Pay
Obligation Acceleration – obligations become due due to default
Repudiation Moratorium – prevented from making payment
Restructuring – reduction of principal or payments
Settlement:
Any bond ranked pari passu can be used for “cheapest to deliver”
If no reference obligation is specified, senior unsecured debt is assumed.
Settlement is typically physical, meaning physical bonds are delivered for par.
Credit Event Notice – 30 days – Notice of Physical Settlement – 30 days – Settlement – 5 days – Buy-in whereas seller tries to buy bonds from open market and charge the buyer the difference.
Settlement can also be cash.
Duration:
Using 5 years from effective date to termination date
Pricing:
To replicate a CDS for the seller:
• Buy a fixed rate note, which provides the coupon payment as the CDS cash flow
• The initial cost of the bond is obtained by lending the bond out on the Repo market
• The bond is traded close to par so that capital at risk – notional minus recovery, is similar
If the bond is not traded close to par but trade at a premium, the bond would carry more risk because cost – recovery would be higher.
The transfer of risk is thus
• Buyer pays the risk premium of the bond, the coupon above Libor, in exchange that he can sell the bond at face value. This is equivalent to turning a bond into treasury.
• Sellers get the extra risk premium in exchange for getting stuck with the bond upon credit default.
• The seller is effectively long a bond and short a treasury.
• The price floor of a CDS is thus the cash spread, or the risk premium.
When a bond is traded at close to recovery value, where implicit default is imminent, alternative quotation methods are used:
Points Upfront
• One single payment quoted in bond points, paid at initiation, good till maturity
• One upfront payment plus a stream of smaller payments till maturity
• Typically for maturities up to 1 year
• Upfront payment plus bond value must be above par to prevent getting free coupon payment from buying the bond with repo funding and no default risk
The initial payment is basically the present value of all running premium until maturity. Paying upfront removes future payment uncertainty
Pricing Envelope:
The price of a CDS is limited by:
• The borrowing cost of an AAA institution. For instance, if the CDS sells for xbp and the institution can borrow at xbp below Libor, the institution can borrow unlimited amount of money and buy the bond and CDS and keeps the coupon at no risk. So the price floor of a CDS is xbp.
- Let’s say Libor is at 5%. A bond yields Libor + 1% = 6%, where the 1% is the risk premium and is the cost of the CDS. An institution borrows at 4%, and thus can buy as much 6% bond as it can because it can afford to also buy the CDS. As a consequence, the cost of the CDS will be bid up to over the risk premium and the risk premium + financing cost advantage becomes the price floor.
• The borrowing cost of an A institution. For instance, if the institution borrows at xbp above Libor and the CDS sells for above xbps, the institution simply sells the CDS instead of borrowing at Libor+xbps to buy the bond which yield > Libor+xbps.
- Let’s say Libor is at 5%. A bond yields Libor + 1% = 6%. The borrowing cost is 5.5%. So instead of borrowing at 5.5% to buy a 6% bond and pocket .5%, the institution can just sell the CDS and pocket the whole 1% premium. In both cases the institution is exposed to the same default risk. As a consequence, the selling price of the CDS will be driven down until the premium is close to the borrowing cost disadvantage, which becomes the price ceiling.
• The price envelope of the CDS is thus determined by the finance costs of the transacting parties.
• The price floor is thus 2% (1% risk premium + 1% buyer borrowing cost advantage) and the price ceiling is thus 0.5% (1% risk premium – 0.5% seller borrowing cost disadvantage).
The price of a CDS is influenced by:
• The buyer recovers the full notional of a bond instead of the market value, which raises the premium of the CDS.
The price of a CDS is determined by:
• Default probability
• Recovery rate
• Time to maturity
• Seller contra risk
Mark-to-Market is determined by
• spread between contract premium and market premium
• The buyer and seller’s MTM are the same but opposite
• Calculated as a present value of an annuity representing the difference between the contract premium and the market premium, weighted by survival probability
The importance of credit derivatives:
• Credit derivatives allow the disaggregation of credit risk from other risks
• inherent in traditional credit instruments.
• Credit derivatives provide an efficient way to short a credit.
• Credit derivatives create a market for .pure. credit risk that allows the
• market to transfer credit risk to the most efficient holder of risk.
• Credit derivatives provide liquidity in times of turbulence in the credit markets.
• Credit derivatives provide ways to tailor credit investments and hedges.
• Credit derivative transactions are confidential.
