Credit Default Swap (CDS)

Finanzas Empresariales II

Omar Pernas López-Sarry

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Index• Introduction• Credit Default Swap• Example• Conclusions• Bibliography

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Index• Introduction• Credit Default Swap• Example• Bibliography

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What’s a financial derivative?Derivatives are financial instruments whose payoffs

derive from other, more primitive financial variables such as a stock price, a commodity price, an index level, an

interest rate, or an exchange rate.

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Composi t ion of g lobal der ivat ives contracts by t rad ing arrangement as at the end of 2014 by outstanding gross not ional va lue

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How can derivatives be used?• Forwards and futures: to hedge an existing

market exposure.• Options: to obtain downside protection to an

exposure even while retaining upside potential.

• Swaps: to transform the nature of an exposure.

• Credit derivative: to obtain insurance against events such as default.

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Size of global OTC derivatives markets by outstanding gross notional value

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What’s gross notional outstanding value?

Notional outstanding refers to the principal amount of the contracts.

• If a forward contract calls for the delivery of 1,000 oz of gold at a price of $1,800/oz, the notional outstanding in the contract is $(1, 800 × 1, 000) = $1.80 million.

• If an option gives the holder the right to buy 10,000 shares of Google at $500/ share, the notional outstanding in the contract is $(10, 000 × 500) = $5 million.

• If a swap calls for the exchange of floating cash flows for fixed cash flows on a principal of $100 million, the notional outstanding in the swap is $100 million.

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What’s a credit derivative?

Credit derivatives are derivatives written on the credit risk of an underlying reference

entity. Isolate credit risk from other risks present in an asset. Are off-balance-sheet

instruments.

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Isolation and separate trading of credit risk

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Credit Derivative Market Growth

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Types of credit derivatives• Credit Default Swap (CDS)• Total Return Swap• Constant Maturity Credit Default Swap (CMCDS)• First to Default Credit Default Swap• Portfolio Credit Default Swap• Secured Loan Credit Default Swap• Credit Default Swap on Asset Backed Securities• Credit default swaption• Recovery lock transaction• Credit Spread Option• CDS index products

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Index• Introduction• Credit Default Swap• Example• Bibliography

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CDS: definition

A Credit Default Swap (CDS) is a kind of insurance against credit risk.

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How does a CDS work?

Protection buyer(short position)

Protection seller(long position)

Bp per annum

Contingent payment

Credit event

• Municipal bonds• Emerging market

bonds• Mortgage-backed

securities• Corporate debt

Reference entity

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Three main types of CDS• Single name: The reference entity is an individual

corporation, bank, or government.• Index: CDS referring to multiple constitutent entities in

the index with each entity having an equal share of the notional amount. The degree of standardisation is highest for these contracts.

• Basket CDS: CDS with more than one reference entity (typically between three and one hundred names). Specific types include first-to-default CDS, full basket CDS, untranched basket and tranched basket known as a synthetic CDO.

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Types of credit events• Bankruptcy: where the reference entity becomes bankrupt

or suffers an analogous.• Failure to pay: where the reference entity fails to make a

payment of interest or principal.• Obligation default: where the reference entity defaults on

one of its obligations.• Repudiation/moratorium: where the reference entity

repudiates or declares a moratorium over some or all of its debts.

• Restructuring: where the reference entity arranges for some or all of its debts to be restructured causing a material change in their creditworthiness.

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CDS featuresSize Averaging $25 to $50 million per

transaction.

Time to maturity 1 to 10 years.

Transaction method

Direct contracting and trading between the seller and the buyer

Guarantees required Not if rated >= AA

Secondary market Existent

Settlement Whole losses or gains at maturityGuarantying institution The own contracting partiesContract

compliance Physical delivery or cash settlement

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CDS uses: hedging and Speculat ion

• An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract.

• CDS provide a very efficient way to take a view on the credit of a reference entity.

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CDS: Market risks• The market for CDS is OTC and unregulated.• Contracts often get traded so much that it is hard

to know who stands at each end of a transaction.• Counterparty risk.• The possibility that a widespread downturn in the

market could cause massive defaults and challenge the ability of risk buyers to pay their obligations.

• Leverage.

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Index• Introduction• Credit Default Swap• Example• Bibliography

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AIG’s involvement in mortgage backed secur i t ies (MBS)

Protection buyer:Lenders, investors

Protection seller:AIG

Bp per annum

Contingent payment

Credit event:Sub-prime crisis

Reference entity

Mortgage Backed

Obligations (MBO)

Returns on different tranches

Borrowers

Borrowers

Principal + Interest

$180 billion bailout

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The Big Short

https://www.youtube.com/watch?v=Cxjdj5_5yNM

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CDS from business newspaper

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The evolut ion of average 5-years weekly CDS spreads (bp) for strong-economy countr ies

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The evolution of average 5-years weekly CDS spread (bp) for PI IGS

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Index• Introduction• Credit Default Swap• Example• Bibliography

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Bibliography• The J.P. Morgan guide to credit derivatives• Credit derivatives: an overview, Federal

Reserve of Atlanta• Derivatives in Financial Market Development,

International Growth Centre, February 2013• Credit Default Swaps and counterparty risk,

European Central Bank, August 2009