Credit default swap aapu

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Credit default swap aapu

  1. 1. CREDIT DEFAULT SWAP FAHAD . P
  2. 2. Objective of the study To study how CDS can be used for hedging the default risk or counter party risk.
  3. 3. Introduction  Credit default swaps (CDS) are the building blocks in the credit derivatives market and represent half of its volume.  CDS is bilateral contract between a protection buyer and protection seller that exchanges the credit risk or a specific issuer (reference entity).  The protection buyer (short the credit) pays a premium to the protection seller (long) to assume the risk associated with particular credit event.  Credit events are typically defined to include bankruptcy, material default, and debt restructuring for a specified reference asset.
  4. 4. Meaning  A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.  in the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.
  5. 5. CDS Terms  In the standard CDS, payments are usually made in arrears either on a quarter, semiannual, or annual basis.  The par value of the bond or debt is the notional principal used for determining the payments of the buyer.  In the event of a default, the payoff from the CDS is equal to the face value of the bond (or NP) minus the value of the bond just after the default.  The payments on a CDS are quoted as an annual percentage of the NP. The payment is referred to as the CDS spread.
  6. 6. CDS Uses  CDS are used primarily to manage the credit risk on debt and fixed-income investment positions.  Default or credit event – Examples include ; ◦ Bankruptcy ◦ Failure to pay ◦ Restructuring ◦ Repayment Acceleration on Default (cross default clauses) ◦ Repudiation
  7. 7. Buyers of CDS Protection
  8. 8. Credit Derivatives by region 43% 5%10% 39% 3% London Europe ex-London Asia/Australia US Other
  9. 9. Motivations for using Credit Default Swaps Advantages : 1. Trading/ market making 2. Product structuring 3. Hedging trading instruments 4. Active portfolio/ asset management 5. Management of economic capital 6. Management of regulatory capital 7. Management of individual credit
  10. 10. Disadvantages : 1. Lack of client knowledge of the product 2. Regulatory constraints 3. Systems / Infrastructure 4. Pricing – lack of data 5. Lack of agreed accounting conventions 6. Lack of homogenous documentation 7. Lack of market liquidity and depth
  11. 11. Working or Usage of CDS :  As Hedging Risk  As Speculation
  12. 12. CDS as Hedging risk  Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt
  13. 13. HEDGING Notional 10000000 Premium (%) 2% Premium (Rs) 200000 Duration 5 year quarterly payment 50000 IF DEFUALT HAPPENS : PB receive from counter party 0 PB receive from PS 10000000 Premium paid (5 yr) 1000000 Net Amount 9000000
  14. 14. IF NO DEFUALT HAPPENS : END OF 5 YEARS PB will receive end of 5 years 10000000 premium paid for CDS to PS 1000000 Net amount 9000000
  15. 15. Speculation  An investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by entering into a trade.
  16. 16. SPECULATION NOTIONAL AMOUNT 10000000 DURATION OF CDS 2 YEAR SPREAD 500000 IF DEFUALT HAPPENS : AFTER 1 YEAR PREMIUM PAID 500000 SPECULATOR RECIEVES 10000000
  17. 17. IF NO DEFUALT : PREMIUM PAID 1000000 PROTECTION BUYER'S LOSS 1000000 PROTECTION SELLER GAIN 1000000
  18. 18. CONCLUSION  CDS Is The One Of The Best Instrument Available In The Market For Any Business Entity Against Default Risk , It Will Help Them To Reduce Their Counter Party Loss Rather Than Making Profit.

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