2. INTRODUCTION TO CDS
It is a Financial Swap Agreement between Two counterparties.
Where the Protection Seller will compensate the Protection
Buyer.
In the Event of Loan Default or other Credit Events.
The Protection Buyer makes a series of payments to the
Protection seller and in turn receive the payoff if the loan
Defaults.
It is Simply a Credit Derivative.
CDS are not traded on any Stock exchange.
3. UNDERSTANDING THE TERMINOLOGIES
Protection Buyer: Purchaser of Credit Default Swap
Protection Seller: seller of Credit Default Swap
Reference Entity: Entity who has Borrowed Funds. RE is not a party
to the contract.
Credit Event: Failure to pay, Restructuring, Bankruptcy or even a
drop in the borrowers credit rating.( most Important Risk Factor)
Spread: annual amount of the contract the protection buyer must
pay to protection seller over the length of the contract. This is
expressed as Bps I.e. Basis Points.
4. EXAMPLE OF CDS
suppose that Citi Bank has lent money to Microsoft Corp in
the form of a $1,000 bond.
Citi Bank may then purchase a credit default swap from
another company e.g. a Hedge Fund / Derivative Bank.
If the firm (Microsoft Corp ) default on the loan, then the
Derivative Bank will pay Citi Bank the value of the loan.
Thus Citi Bank have insurance against loan default. The
Derivative Bank has the opportunity to make profit, so long
as the firm does not default on the loan.
The more risky the loan, the higher will be the premium
required on buying a credit default swap.
Premium expressed in term of bps ( Basis Points ).
6. ANALYSIS OF THE EXAMPLE
Citi Bank is the Protection Buyer
Hedge Fund is the Protection Seller
Microsoft Corp is the Reference Entity.
Citi Bank will have to pay premium to the Hedge fund in the
same way as insurance premium are paid.
On default Hedge Fund will pay the amount to the Citi Bank
and CDS Contract will terminate.
CDS is not a Insurance Contract.
Bps is the Indicator of the Risk.
7. RISK
When entering into the CDS both the Buyer and Seller of
Protection takes on Counterparty Risk.
Buyer takes the risk that seller may Default. Default at time of
making One time Payment.
Seller takes the Risk that Buyer may Default. Default in the
payment of Stream of Spreads.
Another kind of risk for the seller of credit default swaps is
jump risk or jump-to-default risk. A seller of a CDS could be
collecting monthly premiums with little expectation that the
reference entity may default. A default creates a sudden
obligation on the protection sellers to pay millions, if not
billions, of dollars to protection buyers.
8. SPREAD-
The spread is the annual amount the protection buyer must
pay to protection seller.
It is paid over the length of the contract.
Expressed as percentage of Notional Amount.
Example: If CDS Spread is 50 bps I.e. 0.50%, then investor
buying CDS protection worth $10 Million must pay $50,000 to
protection Seller.
Payments are usually made on Quarterly basis, in arrears.
9. These payments continue until either CDS Contract expires or
Reference entity defaults.
All things being equal, at any given time if maturity of two
credit default swap is same then
Reference Company CDS Spread Risk of Default
A 50 Lower
B 60 Higher
10. WHETHER IT IS AN INSURANCE CONTRACT?
CDS Contract have been compared with insurance,
because buyer pays the premium and in return receive
the sum of money if one of the defaulting event
specified in the contract occurs.
However there are number of differences between
insurance contract and CDS
Buyer of CDS doesn’t need to own underlying security
In fact the buyer need not to suffer the loss from defaulting
event.
Insurance contract provides an indemnity against the losses
actually suffered.
Cost of insurance is based on actuarial analysis. CDS are
derivatives whose cost is determined using financial models.
The CDS is not an Insurance.
11. USES OF CDS
Speculation – Profit making through price changes
Hedging – Insulation against price risk
Arbitrage – look for opportunity that arise out of the product
being price differently in two markets. ( Capital Structure
Arbitrage is an example of arbitrage strategy that utilizes CDS
transaction. )
12. NAKED CDS
A CDS in which the buyer doesn't own the underlying
debt is referred to as Naked CDS.
There is a debate in the US and Europe that whether
speculative uses of CDS should be banned.
Critics asserts that Naked CDS should be banned,
comparing them to buying fire insurance on your
Neighbor’s house, which creates huge incentives for the
arson.
Proponents of Naked CDS says that it increases liquidity
in the market and also benefits hedging.
13. SETTLEMENT
If the credit event occurs then CDS Contract can either be
Physically settled or Cash Settled.
Physical Settlement
The Protection seller pays the buyer par value and In turns take
delivery of a debt obligation of reference entity. Example: A Hedge
fund has Bought from a Derivative Bank $5 Million protection on a
Debt of the Company. In the event of default the Derivative bank
pays the fund $5 Million and Hedge Fund must deliver $5 Million
face value of Debt of the reference company.
14. Cash Settlement
The protection seller pays the buyer the difference between par
value and market value of Debt Obligation of the reference entity.
Example: A Hedge fund has Bought from a Derivative Bank $5 Million
protection on a Debt of the Company. This company has now
defaulted and its bonds are now trading @ 25% of value, since the
market believes that bondholder will receive 25% of the money they
are owed once the company is wound up. Therefore the bank must
pay the hedge fund only 75% ( 100% - 25% ).
15. WHY CDS?????
JP Morgan Stanly was trying to get its head around a
Question: How do you mitigate your risk when you loan
money to someone?
By mid 90s JP Morgan's Book was loaded with Billions of
Dollars in Loan to corporations and Foreign
Governments.
It had to keep huge amount of capital in reserves as per
Basel II norm.
It created a device that would protect it if those loan
defaulted, and free up that capital adequacy
requirement.
Unregulated CDS allowed banks to get around the Basel
rules.
16. CDS-NUCLEAR BOMB
Like Robert Oppenheimer and his team of nuclear
physicists in the 1940s, JPMorgan didn't realize they
were creating a monster.
The country's biggest insurance company, AIG, had to be
bailed out by American taxpayers after it defaulted on
$14 billion worth of credit default swaps it had made to
investment banks, insurance companies other entities.
There's a reason Warren Buffett called these
instruments "financial weapons of mass destruction."
Since credit default swaps are privately negotiated
contracts between two parties and aren't regulated by
the government, there's no central reporting
mechanism to determine their value.
