The Usage of Credit Default Swaps for Risk Management at Government Bond Markets Božena Chovancová 1, Peter Árendáš 2, Ján Horvát 3 University of Economics in Bratislava, Bratislava, Slovak Republic 1 bozena.chovancova@euba.sk, 2 p.arendas@centrum.sk, 3 jan.horvat3@gmail.com Abstract The last decade has been associated with a vast expansion of securitization processes and the usage of derivatives on capital markets. The growth of credit risk has been transferred also into the government bonds, which had been considered a safe investment and a portfolio stabiliser before. The debt crisis in Europe, which is associated with the growth of the government budget deficits, has resulted into increasing risk of government bonds emissions. The need of hedging these risks has led to a rapid expansion of credit default swaps (CDS). The aim of this article is to analyse the mechanisms of credit default swaps, their advantages and disadvantages and to show the risks underwent by market subjects that overtake the risks. Keywords: Credit risk, hedging, rating, basis points, suretyship share JEL: G01, G15, G18 I. INTRODUCTION The global capital markets have survived a big boom of bond issues during recent decades. The market has absorbed not only a large amount of government bonds, but also lots of corporate bonds. Along with this, the volume of credit derivatives has increased as well. The worsening global situation and the collapse of many large financial institutions have changed the view of market participants on credit risk after the financial crisis. Simultaneously with these processes, the financial theory about innovative financial tools that include also credit default swaps was being developed. An important role of the financial theory is to pinpoint the potential negative consequences of too intensive usage of the modern financial instruments. Some of the most important economists that deal with the topic of credit default swaps are F.J. Fabozzi and V. Steven (2010), who studied this topic in context of the financial crises in South America. M. Choudry (2006) analyses the possibilities of hedging the credit risks by using credit default swaps. D. Boberski (2009) has studied the connection between the global financial crisis and the usage of credit default swaps. There are also some experts in Czech republic and Slovakia that deal with the CDS issues. Most important of them are J. Jílek and P. Markovič (2006). II. BASIC CHARACTERISTICS OF CREDIT DERIVATIVES What we mean by credit derivatives? Credit derivatives are instruments that allow the transfer of credit risk from one market participant to another, respectively from a bank on an investor. These derivatives have been invented in order to reduce the risk that stems out of an eventual default. The segment of credit derivatives is one of the fastest growing segments of financial markets in recent years. A huge part of the credit derivatives market covers the emerging market countries. The credit derivatives are often created simultaneously with the issuance of bonds or confirmation of the loan. On the other hand they are often bought not with the intent of hedging risks but just for speculative reasons. Hence they are also perceived as a speculative financial instrument. The purchase of a credit derivative with the intention of hedging a credit risks is called going 127
short the credit. The main principle of credit derivatives is to separate the credit risk and to trade with this separated risk on financial markets. In a case of the credit event, the seller of the risk (for example a bank) receives compensation from the buyer of the risk (mostly another bank). The amount of the compensation is set independently of the real damage that has occurred. The price for the transfer of the risk is a payment or a sequence of payments from the seller of the risk to the buyer of the risk. There arises no change in the relation between the creditor and the debtor. Credit derivatives include a plenty of non-standardized swaps and option agreements that allow the transfer of credit risk from one entity to another. Besides securitisation, they present also an opportunity for transfer of credit risks. One of the most popular credit derivatives is credit default swap. III. CREDIT DEFAULT SWAP Credit default swap is a financial derivative based on the transfer of credit risk from one entity to another. Credit default swaps are able to quantify the credit risk that is in the case of bonds connected with interest rate risk, liquidity risk and currency risk. These contracts also help the banks to secure their portfolios for the case of default of their clients. They can also overtake the credit risk without the need of costly financing. The substance of the CDS is an exchange of series of payments that are denominated in one or more currencies simultaneously. The counterparties make an agreement where the buyer agrees to pay the seller fixed periodical payments during the lifetime of the CDS. The payments use to be on a quarterly, half-yearly or annual basis. They are expressed in basis points of the nominal value of the asset that is being secured. The CDS buyer obtains protection in the case of a credit event. All the details about the credit event and subsequent compensation payment must be specified in the agreement. Thence resulting that CDS is a specific form of insurance. The underlying asset can be for example the market value of a stock company (reference subject). The reference subject doesn t have to have any relation to any of the CDS agreement participants. It means that it can be made only for speculative reasons. In the case of default of the reference subject, the CDS seller pays the CDS buyer a before determined amount and the life of the CDS is over. If there is no credit event, the value of the CDS at the end of its life is zero (the CDS seller has no commitment to the CDS buyer). CDS is an important tool of risk management. It is often used in order to fulfil the regulatory capital requirements. The payment can have form of a predetermined cash payment or sale of the underlying asset for its nominal value. If the reference entity goes bankrupt, the seller of the swap will pay counterparty an amount of money. But most of CDS agreements demand the delivery of the underlying asset in the case of default of the reference subject. But when it has defaulted, the market with its stocks stops to exist. Therefore the preferred form is a delivery of bonds or other securities of the defaulted subject. But when there was a huge amount of credit derivatives, the need to deliver the bonds of the defaulted subject can lead to growth of its prices. IV. BONDS AND CDS If the underlying asset are bonds (reference obligation), the credit default swap is often constructed in such a way that in the case of credit events the holder of the CDS has the right to sell bonds to the seller of the CDS. Periodic payments (also called a premium) that the buyer of the CDS has to pay the seller of the CDS use to be a couple of basis points of the reference value per year. This premium is also called CDS spread. The reference value 128
mostly equals the value of the obligation at the time of closing the credit default swap agreement. The volume of the premium depends on the quality of the underlying asset, the quantity and types of credit events agreed in the contract, the probability of default of the underlying asset, the probability of default of the reference entity, exposure at failure, etc.. The basis for a CDS spread is the credit rating and the basis points associated with it. The following table shows elemental point values for particular credit rating levels. Table 1: Ratings and basis points (January 2013) Investment Grade Speculative Grade Rating Points Rating Points Aaa 0 Ba1 240 Aa1 25 Ba2 275 Aa2 50 Ba3 325 Aa3 70 B1 400 A1 85 B2 500 A2 100 B3 600 A3 115 Caa1 700 Baa1 150 Caa2 850 Baa2 175 Caa3 1000 Baa3 200 D Source: Own processing, using data of www.damodaran.com V. TYPES OF CDS HEDGING There are two basic variants of hedging risks through credit default swaps: - Credit risk insurance - Regular exchange of payments The first alternative implies that the investor (buyer of the protection) pays a swap premium (gradually or at once) in return for the conditional payment in the case of a credit event. The advantage of this mechanism is the fact that the investor retains all the revenues of the underlying asset and a potential negative return (decrease of the value of the underlying asset) is compensated by the contingent payment from the CDS seller (swap counterparty). 129
Scheme 1: Credit risk insurance Source: Own processing Second alternative is based on a regular exchange of payments. The investor (buyer of the protection) forwards to the swap counterparty all the returns from the underlying asset as an exchange for predetermined interest payments. In the case of a credit event the investor receives predetermined interest payment as well as the contingent payment. 130
Scheme 2: Regular exchange of payments Source: Own processing As it is clear from the definition of credit default swap, the contract has a similar nature as other different types of guarantees. It has character of an option because the credit event is conditioned by reality. It is a swap, because the payments of the premium to the seller are made periodically during a pre-agreed time period. The actual amount of the premium is determined by the number of basis points (1 basis point = 0.01 %) and the nominal value of the reference asset. The mere quantification of the number of basis points is based on the credit rating of the reference asset or its issuer. For illustration of the procedure of determining the amount of the premium and a better understanding of this mechanism, we include the following example: A government has issued government bonds with 5 years maturity. Its credit rating is determined by the Standard & Poor's rating agency is CCC with the corresponding value of 700 basis points p.a. Thence resulting that in this model case the issuer is a government with 131
very bad credit rating which means a higher probability of a credit event. An investor has bought government bonds with nominal value of 1 000 000 EUR and yield of 9% p.a. The investor is afraid of a credit event which could occur during the next 2 years. Therefore he decides to hedge this risk by buying CDS. An investment bank is willing to overtake the risk for premium of 700 basis points per annum with semi-annual payments. It means that the investor (CDS buyer) will pay the bank 35 000 EUR every six months during the next 2 years. Table 2: The model case I. The country fulfills its liability accruing from the bond Investor Investment Bank Principal repayment 1 000 000 Insurance (7% p.a.) 140 000 Yearly yields (5 x 90 000) = 450 000 Insurance (7% p.a.) -140 000 II. The country doesn t fulfill its liability accruing from the bond Investor Investment Bank Compensation paid by the investment Compensation paid to bank 800 000 the investor -800 000 Insurance -140 000 Insurance (7% p.a.) 140 000 Yearly yields???* *according to the number of realised payments Source: Own processing The whole situation can be analysed in terms of risk transfer, credit exposure and financing of reference asset: - The investment Bank (CDS seller) has taken the risk of default of the reference asset over, without reference asset financing. - The investor (CDS buyer) has hedged the credit risk of the reference asset for two years, but he has also opened a credit exposure against an investment bank, because he is dependent on whether the investment bank will be able to implement a compensation payment in the case of a credit event. If the country would be able to pay its obligations, the CDS contract will expire after 2 years. Otherwise, at the moment when the country is unable to pay its obligations, the investor stops paying premium the investment bank and the investment bank will pay a predetermined amount: the difference between the market price and the par value (nominal value of the bond), it redeems the bond at a price of par or it pays a predetermined amount (depending on how it is anchored in the contract e.g. 80 % of the nominal value). Comparing any two CDS contracts that have all the parameters identical (including liquidity and maturity of the contract), differing only by the reference issuer, then the issuer of the reference asset to which the contract binds with higher spreads is perceived as more risky - is more likely that he will become a victim of a credit event. The CDS seller tries to use higher spreads to compensate higher risk of potential contingent payment. One of the biggest sellers of CDS contracts was the insurance company American International Group (AIG), which offered banks hedging of risks especially related to 132
mortgage backed securities. During the financial crisis of 2008, the U.S. government had to save AIG from default because of the enormous amount of contingency payments it had to pay out after the collapse of financial markets. But the potential damages caused by excessive usage of credit default swaps are limited not only to the financial institutions. VI. CONCLUSION Financial turbulences on global capital markets have shown that the volume of credit default swaps had grown up to astronomical numbers, showing that today it is not only a tool of protection against insolvency of the issuer, but also an instrument of speculation. The praxis has shown that a single underlying asset is a subject of multiple hedges. Another huge problem is that the risk is often transferred to entities of doubtful quality. REFERENCES [1] BOBERSKI, D.: CDS Delivery Option, Better Pricing of credit Default Swaps, Bloomberg 2009 [2] FABOZZI, F. J., STEVEN V. Mann: Introduction to fixed income analytics : relative value analysis, risk measures, and valuation, John Wiley & Sons 2010, [3] CHOUDRY Moorad: Credit Default Swap Basic, Bloomberg 2006, [4] Jílek, J. 2002. Finanční a komoditní deriváty. 1. vydanie. Praha: GRADA Publishing, 2010. [6] KRICHEFF, R.S, KENT, J.: The Role of Credit Default Swaps in Leveraged Finance Analysis, Pearson Education, Inc., FT Financial Times, 2013 [7] MARKOVIČ, P.: Finančné riziko vo finančnom rozhodovaní podniku, Ekonóm 2003 [8] WEITERS, T. 2010: Credit D, Derivates, Makro Risks, and Systemic Risk, Economic Review, April 2010 [9] MENGLE, D. 2010: Credit Derivates An Overview, Economic Review, April 2010 [10] www.damodaran.com [11] www.ecb.org [12] www.imf.org 133