CDS definition. How does a CDS work?. CDS examples.

1. 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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Composition of global derivatives
contracts by trading arrangement as at
the end of 2014 by outstanding gross
notional value

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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 features
Size
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 maturity
Guarantying
institution
The own contracting parties
Contract
compliance
Physical delivery or cash settlement

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CDS uses: hedging and Speculation
• 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
securities (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 evolution of average 5-years
weekly CDS spreads (bp) for strong-
economy countries

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

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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