Credit Default Swaps (CDS)

Transcription

1 Introduction to Credit Default Swaps (CDS)

2 CDS Market CDS provide investors with the ability to easily and efficiently short credit Shorting allows positions to be taken in forward credit risk ik CDS allow hedgers or speculators to take an unfunded position solely on credit risk The market has grown from $80 billion in notional in 997 to $5 trillion by 2004 and the current estimate of the market size is $7 trillion in notional** ** On Top of the World, Economist, April 27, 2006,

3 CDS Cashflows A Credit Default Swap (CDS) is an insurance policy between two parties that protects the buyer against the loss of principal p on a bond in case of a default by the issuer Protection o Buyer Quarterly Premium Protection on Default Protection Seller

4 CDS Cashflows $5MM PPL CDS, Price: 49bps Default Protection Buyer $6,25 $6,25 $6,25 $6,25 $6,25 3m 6m 9m 2m 5m 60m Protection Seller $3,000,000

5 Default Events Cash Settlement in Case of Default Protection Buyer Par Recovery Value Protection Seller Physical Settlement in Case of Default Deliverable Obligation Protection Buyer Par Protection Seller

6 Credit Events A CDS is triggered by an event that has a material impact on the cashflows of the debt obligation. A credit event may include: Bankruptcy Issuer becoming insolvent Failure to pay a coupon Obligation acceleration Repudiation Moratorium Restructuring t (if CDS is type R or Mod-R )

7 Contract Details The contract specifically references the precise name of the legal entity in which it provides protection It is important to know the exact legal entity and seniority of the capital structure as covered by the CDS Change in ownership of the bonds can change the underlying reference entity of the CDS

8 Contract Details (cont.) Since 2002, in order to increase liquidity, a vast majority of CDS contracts have standardized quarterly payments on the 20 th of March, June, September and December Credit events and settlement procedures in case of default can be specifically defined within the contract CDS contracts have become increasingly standardized as the market expands

9 Valuation The exposure of any investment in a given issuer s s credit is defined by the equation: EL = EAD LGD P(D) EL=Expected Loss EAD=Exposure at Default LGD=Loss Given Default P(D)=Probability P bilit of Default

10 Valuation (Cont.) We can use a binomial model to value a simple one period CDS where protection was sold C No Default (-P) P R = P = C = -(-R) Default Recovery Rate Probability of Default in Period One CDS Spread (Coupon) for One Period

11 Valuation (Cont.) Two Periods (-P2) C2 C (-P) P2 -(-R) P -(-R)

12 Valuation (Cont.) At the inception of the swap, the present value of the coupon payments (spread) is equal to the present value of the expected default cashflow ( P ) C ( P ) ( P2 ) C2 ( R ) P ( R ) ( P ) P + = r ( + r ) + r ( + r ) PV of Spread Payments PV of Default Payment

13 Example Calculation Issuer: One Year Spread: IBM 7 bps Assumed Recovery Rate: 40% One Year Libor Rate: 5.64% Calculate the Implied Survival Probability

14 Example Calculation (Cont.) ( P P ) C ( R) = r + + r Solving the equation for P we get: P C = + + C R P = =.65% Survival Pr obability = ( P ) = (.65%) = 99.88%

15 Example Calculation 2 Deal Spread: Issuer: 2 bps IBM CDS Notional: $00M Term: Year Assumed Recovery Rate: 40% One Year Libor Rate: 5.64% Par Curve Implied Survival Probability: 99.88% Calculate the PV of a sell protection position

16 Example Calculation 2 (Cont.) PV = ( P ) C ( R ) P + r + r PV = (.0065) $00,000, (.4).0065 $00,000, Present Value = $47, *You will notice that if you replace the.002 with.0007, the value of this contract t is equal to zero.

17 Recovery Rates An underlying assumption in the valuation of a credit default swap is the recovery rate, or the value of the bond issue after a default occurs The valuation can be altered significantly if the recovery rate is different from a market average of approximately 40%

18 Recovery Rates (Cont.) Let us create a fictitious example in which the survival probability for year one is 93% (GM). We will value a contract with a spread of 400 bps with a recover rate of both 40% and 60% PV PV = = (.07) $00,000, (.4).07 $00,000, Present Value = -$454,373 (.07) $00,000, (.6).07 $00,000, Present Value = +$870,882 Difference = $,325,260

19 Recovery Rates and PAR CDS Spreads Consider the market value of a 5 yr. $00M CDS with a deal spread of 400 bps under different scenarios: Market CDS Ra ate Recovery Rate 20% 30% 40% 50% 60% 70% 00 bps $.5 $2.2 $2.9 $3.6 $4.4 $ bps $5.5 $6.9 $8.3 $9.7 $.0 $ bps $0.0 $2.0 $4.0 $6.0 $8.0 $ bps ($5.) ($2.6) $0.0 $2.6 $5. $ bps ($9.8) ($6.8) ($3.7) ($0.6) $2.5 $ bps ($4.2) ($0.6) ($7.) ($3.5) $0.0 $ bps ($8.2) ($4.2) ($0.3) ($6.3) ($2.3) $.7 Dollar Amounts in Millions

20 Trade Example Deal Spread: 2,000 bps CDS Notional: $00M Term: 5 Years Assumed Recovery Rate: 50% Yearly Payment: $20M Default Payout: $50M Breakeven Point: $50M/$20M = 2.5 Yrs

21 Summary Credit Default Swaps have increased the efficiency of the lending market while giving investors an option to easily take on long or short credit exposure The CDS market also provides investors the opportunity to create excess returns by forecasting both recovery rates and survival probabilities