Namdppt fn452

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  • When entering into a CDS, both the buyer and seller of credit protection take on counterparty riskThe buyer takes the risk that the seller may default. First case, if AAA-Bank and Risky Corp. default simultaneously or “double default,” the buyer loses its protection against default by the reference entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.
  • For the seller, they take the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. Therefore, a seller normally limits its risk by buying offsetting protection from another party, that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, they may be able to sell at a lower price than the original CDS and may therefore involve a loss to the seller.
  • As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. It is common that one or both parties to a CDS contract must post collateral. So, there can be margin calls requiring the posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit of one of the parties changes. Many CDS contracts even require payment of an upfront fee.
  • 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 referenceentity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. Therefore, if the seller does not set aside the money to pay to the buyer in case of the default, a huge crisis might follow.
  • Namdppt fn452

    1. 1. C REDIT D EFAULT S WAPS
    2. 2. The Simpsons Company
    3. 3. BONDS 5% 10 years
    4. 4. BONDS BOND BUYER
    5. 5. BOND BUYER CDS
    6. 6. RISK BOND BUYER CDS SELLER
    7. 7. Credit Default Swap
    8. 8. Insurance
    9. 9. BOND BUYER Interests & CREDIT EVENT CDS SELLER Principal REFERENCE ENTITY BOND ISSUER
    10. 10. CDS BUYER BOND BUYER Notional Principal CDS SELLER BOND ISSUER CDS
    11. 11. Periodic payments CDS BUYER BOND BUYER CDS Spread CDS SELLER BOND ISSUER
    12. 12. NO Credit Event CDS BUYER BOND BUYER NO payoff CDS Spread CDS SELLER BOND ISSUER
    13. 13. 1 2 Physical Settlement 100 million = 100 million Credit Event Cash Settlement • Auction to determine the mid-market value of the cheapest deliverable bond • If bond is worth $35 per $100 of its face value • 65 million dollars
    14. 14. Usage of CDS - Hedging - Arbitrage - Speculation
    15. 15. Hedging CDS CDS Seller CDS Buyer Debt Issuer
    16. 16. Arbitrage Capital Structure Arbitrage Stock Price CDS Spread CDS Spread will increase 1. Buying CDS protection 2. Buying underlying stock
    17. 17. Speculation 1. They can buy CDS on bonds they don’t own 2. They can sell CDS to others Will Improve Will default = Buy CDS Sell “ Naked Credit Default Swap ”
    18. 18. Risk Counterparty risk –Taken by buyer BANK Risky Seller Default Counterparty risk Corp. Double Default Risky BANK Corp. Buyer loses its protection against default by the reference entity Buyer needs to replace the defaulted CDS at a higher cost
    19. 19. Risk Counterparty risk - taken by seller Buyer Default Seller can limit loss by hedging its exposure - Unwinding the hedge transaction - Selling a new CDS to a third party
    20. 20. Risk Liquidity risk Require Margin Calls
    21. 21. Risk Default? Seller’s revenue stream Jump-to-Default risk NO WAY
    22. 22. INSURED AAA W ITH CDS
    23. 23. IN THE CASE OF DEFAULT PRIME HOMEOWNER
    24. 24. PRIME HOMEOWNER SUBPRIME HOMEOWNERS
    25. 25. SUBPRIME HOMEOWNERS
    26. 26. DEFAULTED PRIME HOMEOWNER
    27. 27. Enough time bombs!!! No way! Who will buy from me? No! Lost enough money! No! My mom will kill me!
    28. 28. BALANCE SHEET If …. LESS CAPITAL REQUIREMENT
    29. 29. If you have senior tranches of securitization with CDS REGULATORS INSURED WITH CDS
    30. 30. RECKLESS RECKLESS!
    31. 31. TRANCHE $100MIL PRINCIPAL
    32. 32. INVESTOR $1MIL MORTGAGE
    33. 33. TRANCHE TRANCHE $100MIL PRINCIPAL $99MIL PRINCIPAL COMPENSATED $1 MIL
    34. 34. CDS Valuation Trying to find spread or premium that the buyer of protection has to pay
    35. 35. Terms Definition: Default Probability The likelihood that the borrower will not be able to make repayments
    36. 36. Terms Definition: Survival Probability The likelihood that the company will survive and make payments on their debt
    37. 37. Terms Definition: Recovery Rate Amount recovered in the event of a default as a percent of the face value
    38. 38. Assumption • • • • • • Defaults happen at midyear every year throughout life of the CDS Buyer of a CDS make payment annually Risk-free rate = 5% (continuous compounding) Recovery rate = 40% Time= 5 years Probability of default= 2% Defa Defa Def Defa Defa
    39. 39. Default Probabilities and Survival Probabilities Marginal probability of default Cumulative probability of survival Time (years) Default Probability Survival Probability 1 0.0200 0.9800 2 0.0196 0.9604 0.9800x0.9800 3 0.0192 0.9412 0.9800x0.9604 4 0.0188 0.9224 0.9800x0.9412 5 0.0184 0.9039 0.9800x0.9224 Calculated by multiplying default
    40. 40. Valuation Concept PV of Payment made by CDS buyer 1 = Payment 2 Accrual payment When reference firm does When reference firm 3 PV of Payoff made by CDS seller
    41. 41. Step1. Calculation of the PV of Expected Payment 1 Time Probability of (year) Survival 1 2 3 4 5 Total 0.9800 0.9604 0.9412 0.9224 0.9039 2 1 X2 Expected Payment Discount Factor 0.9800s 0.9604s 0.9412s 0.9224s 0.9039s 0.9512 0.9048 0.8607 0.8187 0.7788 PV of Expected Payment 0.9322s 0.8690s 0.8101s 0.7552s 0.7040s 4.0704s Discount factor = e-rt * S= annual
    42. 42. Step 2. Accrual payment made in the event of default 1 2 Time (year) Probability of Default Expected Accrual Payment 0.5 1.5 2.5 3.5 4.5 Total 0.0200 0.0196 0.0192 0.0188 0.0184 0.0100s 0.0098s 0.0096s 0.0094s 0.0092s Remember we assume that the defaults Discount Factor 0.9753 0.9277 0.8825 0.8395 0.7985 Expected Accrual Payment = Prob. Of 1 X 2 PV of Expected Accrual Payment 0.0098s 0.0091s 0.0085s 0.0079s 0.0074s 0.0426s
    43. 43. Step 3. Calculation of PV of Expected Payoff 1 Time 0.5 1.5 2.5 3.5 4.5 Total Probability Recovery of Default Rate 0.0200 0.0196 0.0192 0.0188 0.0184 0.4 0.4 0.4 0.4 0.4 2 Expected Payoff Discount Factor 0.0120 0.0118 0.0115 0.0113 0.0111 0.9753 0.9277 0.8825 0.8395 0.7985 1 X 2 PV off Expected Payoff 0.0117 0.0109 0.0102 0.0095 0.0088 0.0511 Expected Payoff = Prob. Of Default x 0.6 0.6 comes from
    44. 44. Finding CDS spread The mid-market CDS spread for the 5 year deal should be 124 basis point ! Step 1 Step 2 Step 3 4.0704s + 0.0426s = 0.0511 s = 0.0124

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