Investments & Securities Chapter 29 Credit Default Swaps Summary This Describe The Different Types Cds

CHAPTER 29

CREDIT DEFAULT SWAPS

CHAPTERSUMMARY

In this chapter, we describe the different types of CDS, the basics of CDS valuation for

a single-name CDS, and how a CDS can be used to control risk. We begin with the critical

element in a CDS: the definition of a credit event.

CREDIT EVENTS

A CDS has a payout that is contingent upon a credit event occurring. The ISDA provides

definitions of what credit events are.

Credit Events

The 1999 ISDA Credit Derivatives Definitions (referred to as the “1999 Definitions”) provides

a list of eight credit events: (1) bankruptcy, (2) credit event upon merger, (3) cross acceleration,

(4) cross default, (5) downgrade, (6) failure to pay, (7) repudiation/moratorium, and

(8) restructuring. These eight events attempt to capture every type of situation that could cause

the credit quality of the reference entity to deteriorate, or cause the value of the reference

obligation to decline.

The most controversial credit event that may be included in a credit default product is

restructuring of an obligation. A restructuring occurs when the terms of the obligation are

altered so as to make the new terms less attractive to the debt holder than the original terms. The

Credit Events for an Asset-Backed Security

CDS are written on asset-backed securities (ABS) and referred to as ABS CDS. There are unique

aspects of an ABS that required a modification of the ISDA documentation with respect credit

event definitions when the reference entity is an ABS tranche.In June 2005, the ISDA released

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what it refers to as its pay-as-you-go (PAUG) template for ABS. The focus was on cash flow

adequacy of the ABS structure rather than the potential for bankruptcy. Accordingly, the ISDA

PAUG template provided the following three credit events that focus on cash flow adequacy for

ABS transactions:

• Failure to pay. The underlying reference obligation fails to make a scheduled interest or

principal payment.

• Writedown. The principal component of the underlying reference obligation is written

down and deemed irrecoverable.

• Distressed ratings downgrade. The underlying reference obligation is downgraded to

a rating of Caa2/CCC or lower

SINGLE-NAME CDS

In a single-name CDS, there is only one reference entity or reference obligation. There are

single-name CDSs written on a

• corporate debt issuer (bonds or leverage loans)

• sovereign issuer

• municipal bond issuer

• tranche of an asset-backed security

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Given 92 actual days in a quarter and the swap premium of 200 basis points (0.02), the quarterly

swap premium payment made by the protection buyer would be

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Corporation where only one issue of the reference entity was assumed to be outstanding, in the

real world all reference entities have many issues outstanding and therefore there will be

Approximating the Value of a Single-Name CDS

Let’s look at the general principles for pricing or valuing single-name CDS on a corporate bond

issuer. We begin with a set of simplifying assumptions. There are eight assumptions needed to

value a single-name CDS with a maturity of T years for a reference entity. Given these

Let’s look at the payoff for the two possible outcomes: no credit event occurs or a credit event

occurs.

Consider next what would happen if there is a credit event. Assuming physical delivery of the

floating-rate debt obligation, the floating-rate debt obligation is delivered to the credit protection

seller (i.e., the seller of the single-name CDS). Because we assume the credit event occurs right

Asset Swap

When an investor owns an asset and converts its cash flow characteristics, the investor is said to

have created an asset swap. Let’s now illustrate a basic asset swap. Suppose that an investor

purchases $10 million par value of a 7.85%, 5-year bond of a BBB rated corporation at par value.

Let’s look at the cash flow for the investor every six months for the next five years:

Received from bond: 7.85%

Thus, regardless of how interest rates change, if the issuer does not default, the investor earns 85

basis points over 6-month LIBOR. Effectively, the investor has converted a fixed-rate BBB

5-year bond into a 5-year floating-rate bond with a spread over 6-month LIBOR. Thus, the

investor has created a synthetic floating-rate bond. The purpose of an asset swap is to do

precisely that: create a synthetic credit-risky floating-rate security.

An asset swap typically combines the sale of a credit-risky bond owned to a counterparty at par

and with no interest accrued, with an interest-rate swap. This type of asset swap structure or

To illustrate this asset swap structure, suppose that in our previous illustration the swap rate

prevailing in the market is 7.30% rather than 7.00%. The investor owns the bonds and sells them

Let’s look at the cash flow for the investor every six months for the next five years for this asset

swap structure:

Received from bond: 7.85%

In our first illustration of an asset swap, the investor is creating a synthetic floater without

a dealer. The investor owns the bonds. The only involvement of the dealer is as a counterparty to

the interest-rate swap. In the second structure, the dealer is the counterparty to the asset swap

structure and the dealer owns the underlying credit-risky bonds. If there is a default, the dealer

returns the bonds to the investor.

CDS Implied Default Probabilities

In the early days of the CDS market, the following naïve relationship was used to back out

default probabilities from the observed CDS spread:

Note that in the above formula, we use default probability. Given an assumed recovery rate, then

an implied default probability can be obtained by solving the above equation for the default

probability:

INDEX CDS

An index CDS is a CDS written on a standardized basket of reference entities and include CDS

written on

• Corporate debt issuers

• Sovereign government issuers

• Municipal debt issuers

• Tranches of asset-backed securities

• Tranches of commercial mortgage-backed securities

Index CDS Written on Corporate, Sovereign, and Municipal Debt Issuers

The two most actively traded CDX on corporate bonds for reference entities in North America

are the North America Investment Grade Index (denoted by CDX.NA.IG) and the North

America High Yield Index (denoted by CDX.NA.HY).

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In addition to index CDS on corporate bond issuers, there is an index CDS on leveraged loans

(denoted LCDX). What differentiates the LCDX from the corporate bond CDX such as the

CDX.HY is that the LCDX references a collection of loans (i.e., any/all outstanding senior

secured bank debt of the reference issuer).

There are index CDS written on sovereign governments in regions throughout the world. There

is an index CDS written on 50 municipal entities (denoted by MCDX) ranging from general

obligation debt to revenue bonds from municipal authorities.

Index CDS Written on Tranches of ABS

The index CDS written on ABS transactions are called ABX.HE. The index includes 20 home

equity loan deals from the “top 20” issuers at the time. The mechanics of an ABX.HE differ from

Index CDS Written on Tranches of Commercial Mortgage-Backed Securities

There are index CDS written on deals of commercial mortgage-backed securities (CMBS). This

index CDS, denoted by CMBX, consists of deals from 25 CMBS transactions. As with the

ABX.HE, there are sub-indices based on tranche ratings. The PAUG template is used as with the

ABX.HE.

ECONOMIC INTERPRETATION OF A CDS AND INDEX CDS

Credit Protection Seller

Consider first the credit protection seller in a single-name CDS. What is the equivalent position

of the credit protection seller in the cash market? For illustration purposes, we will assume that

the reference obligation is bond ABC. If an investor buys bond ABC, then the investor will have

the following cash flow:

below the purchase price paid by the investor (i.e., PT<P0). The investor then realizes a loss equal

to the PT − P0.

Let’s now suppose that a credit event occurs. The protection seller must make a payment to the

protection buyer. This payment represents a cash outlay or loss for the protection seller. But

consider that there is a loss that occurs for the investor who buys bond ABC if an adverse event

occurs. Once again, this cash flow attribute is similar for both the protection seller and an

investor in a bond.

Credit Protection Buyer

It should be no surprise that if the protection seller in a CDS has a position analogous to a long

position in the cash bond that the protection buyer in a CDS has a position analogous to a short

position in a cash bond. Let’s see why once again using a single-name CDS where the reference

obligation is bond ABC.

The semiannual coupon payments will be made by the investor because the short is responsible

for reimbursing the party that it borrowed the bond from an amount equal to the coupon

payment. This payment occurs as long as bond ABC does not default.

Let’s look at the cash flow for the credit protection buyer where the reference obligation is bond

ABC. This party to the CDS makes a quarterly payment equal to the CDS spread. However, the

swap payments are only made if bond ABC does not trigger a credit event. Thus, as with an

Let’s now suppose that a credit event occurs. The protection buyer no longer must make any

payment to the protection buyer. Consequently, the protection buyer has an economic position

that is analogous to a short position in a cash bond.

USING CDS FOR CONTROLLING CREDIT RISK

Consider a single-name credit CDS written on a corporate reference entity. The liquidity of the

CDS market compared to the corporate bond market makes it more efficient to obtain exposure

to a reference entity by taking a position in the CDS market rather than in the cash market.

For a portfolio manager seeking a leveraged position in a corporate bond, this can be done with

a CDS since the economic position of a protection seller is equivalent to a leveraged position in

a corporate bond.

KEY POINTS

• Interest-rate derivatives can be used to control interest-rate risk with respect to changes in the

level of interest rates. Credit derivatives can be used to control the credit risk of a security.

• By far, the most dominant type of credit derivative is the credit default swap wherein the

protection buyer makes a payment of the swap premium to the protection seller; however, the

protection buyer receives a payment from the protection seller only if a credit event occurs.

An asset swap structured by a dealer firm involves an investor selling a fixed-rate credit risky

bond to the dealer firm and receiving floating-rate payments.

• A CDS valuation model can be used to obtain the implied default probability for a reference

entity. However, the probability calculated depends on the validity of the model and the

estimated inputs.

• The economic interpretation of the credit protection seller is that it is analogous to a leveraged

position in the reference entity (in the case of a single-name CDS) or the standardized basket

of reference entities (in the case of an index CDS). For the credit protection buyer, the

position is analogous to a short position in the reference entity or reference entities.

ANSWERS TO QUESTIONS FOR CHAPTER 29

(Questions are in bold print followed by answers.)

1. How does the role of a credit derivative differ from that of an interest-rate swap in terms

of controlling risk?

Recall that derivatives can be used to control risk (hedging being a special case of risk

controlwhere risk is eliminated) and provide a more transactionally efficient vehicle for doingso.

Thus, a credit derivative controls for a credit risk in a manner that an interest-rate swap cannot.

More details are given below.

An interest rate swap is a derivative involving an agreement between two parties (known as

counterparties) where one stream of future interest payments is exchanged for another based on

a specified principal amount. A company will typically use interest rate swaps to limit or manage

exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it

would have been able to get without the swap.Interest rate swaps expose users to interest rate

risk and credit risk. A typical swap consists of two legs, one fixed, the other floating. Some think

that the risky component is the floating leg, since the underlying interest rate floats and so is

unknown. However, the risky component is in fact the fixed leg because the value of the floating

2. Why is a portfolio manager concerned with more than default risk when assessing

a portfolio’s credit exposure?

3. Answer the below questions.

(a) What is meant by a reference entity?

(b) What is meant by a reference obligation?

4. What authoritative source is used for defining a “credit event”?

The International Swap and Derivatives Association (ISDA) provide definitions of what credit

events are. The 1999 ISDA Credit Derivatives Definitions (referred to as the “1999 Definitions”)

provides a list of eight credit events: bankruptcy, credit event upon merger, cross acceleration,

cross default, downgrade, failure to pay, repudiation/moratorium, and restructuring. These eight

5. Why is “restructuring” the most controversial credit event?

The most controversial credit event that may be included in a credit default swap is restructuring

of an obligation. A restructuringoccurs when the terms of the obligation are altered so as to make

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The reason why restructuring is controversial is that a protection buyer profits from the inclusion

of a restructuring as a credit event and feels that eliminating restructuring as a credit event will

erode its credit protection. The protection seller, in contrast, would prefer not to include

restructuring since even routine modifications of obligations that occur in lending arrangements

would trigger a payout to the protection buyer. Moreover, if the reference obligation is a loan and

the protection buyer is the lender, there is a dual benefit for the protection buyer to restructure

a loan. First, the protection buyer receives a payment from the protection seller. Second, the

accommodating restructuring fosters a link between the lender (who is the protection buyer) and

its customer (the corporate entity that is the obligor of the reference obligation).

6. Why does a credit default swap have an option-type payoff?

A credit default swap has an option-type payoff because the occurrence of a contingent event

triggers the buyer to exercise their right to enhance their value. More details are given below.

Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary

purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default

swaps operate much like a standby letter of credit or insurance policy. In a credit default swap,

the protection buyer pays a fee to the protection seller in return for the right to receive a payment

conditional upon the occurrence of a credit event by the reference obligation or the reference

entity. If a credit event occurs, then the protection seller must make a payment. Because an

7. Comment on the following statement: “Restructuring is included in credit default swaps

and therefore the reduction in a reference obligation’s interest rate will result in the

triggering of a payout. This exposes the protection seller to substantial risk.”

Reduction in a reference obligation’s interest rate is one term of the contract that can cause

a restructuring. This exposes the protection seller to risk because restructuring tends to favor the

protection buyer. More details are given below.