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11.2 credit default swaps
1.
Copyright © 2018
CapitaLogic Limited Chapter 11 Credit Default Swaps This presentation file is prepared in accordance with Chapter 11 of the text book “Managing Credit Risk Under The Basel III Framework, 3rd ed” Website : https://sites.google.com/site/crmbasel E-mail : crmbasel@gmail.com
2.
Copyright © 2018
CapitaLogic Limited 2 Declaration Copyright © 2018 CapitaLogic Limited. All rights reserved. No part of this presentation file may be reproduced, in any form or by any means, without written permission from CapitaLogic Limited. Authored by Dr. LAM Yat-fai (林日辉), Director, CapitaLogic Limited, Adjunct Professor of Finance, City University of Hong Kong, Doctor of Business Administration, CFA, CAIA, CAMS, FRM, PRM.
3.
Copyright © 2018
CapitaLogic Limited 3 Analysis of credit default swaps Functional purpose Capital appreciation Regular income Hedging Speculation Cash flows Outflows Inflows Default protection Which major factors impact the default protection? How? Credit risk EL XCL Neither EL nor XCL
4.
Copyright © 2018
CapitaLogic Limited 4 Outline Single name CDS Binary CDS Basket CDS Portfolio CDS Appendices
5.
Copyright © 2018
CapitaLogic Limited 5 Single name CDS Protection buyer – risk adverse investor If the reference debt defaults, receives default loss of principal = Principal × LGD If the reference debt survives, pays premium regularly Protection seller – risk tolerant investor If the reference debt defaults, pays default loss of principal = Principal × LGD If the reference debt survives, receive premium regularly Example 11.1
6.
Copyright © 2018
CapitaLogic Limited 6 Single name CDS Protection buyer Protection seller Principal × 30 bps every quarter Default protection = Principal × LGD Reference debt + Single name CDS Risk-free security - Single name CDS Reference debt - Risk-free security
7.
Copyright © 2018
CapitaLogic Limited 7 Application of CDS Hedging Protection buyer – long position To mitigate credit risk of a reference debt Investment Protection seller – short position To invest in a debt without upfront cash outflow Regular cash inflows (premiums) Subject to credit risk of the reference debt
8.
Copyright © 2018
CapitaLogic Limited 8 Cash outflows When the reference debt survives Regular premium at arrear quarterly When the reference debt defaults Accrued premium Day count convention follows corporate bond Premium rate Accrued premium = Principal Premium frequency No. of days since last premium payment day No. of days between last and next premium payment days
9.
Copyright © 2018
CapitaLogic Limited 9 Cash inflows In physical settlement, protection buyer Delivers the reference debt to the protection seller Receives the principal in full from the protection seller Net default protection Principal - Principal + Accrued interest × 1 - LGD = Principal + Accrued interest × LGD - Accrued interest
10.
Copyright © 2018
CapitaLogic Limited 10 Cheapest delivery option A CDS designed to protect any one of the reference debts in a group of similar reference debts issued by the same issuer Protection buyer Sell defaulted debt with accrued interest from distressed debt market Buy defaulted debt without accrued interest from distressed debt market Pocket small differential Accrued interest × (1 - LGD) Deliver defaulted debt without accrued interest to protection seller at a net default protection Principal × LGD Total recovery value Principal + Accrued interest × (1 - LGD)
11.
Copyright © 2018
CapitaLogic Limited 11 Cash inflows In cash settlement, protection buyer Receives default protection from the protection seller Principal × LGD Executes the debt collection to recover (Principal + Accrued interest) ) × (1 - LGD) Extension to average EAD protection Debt principal Interest rate Debt principal + 2 Interest frequency
12.
Copyright © 2018
CapitaLogic Limited 12 Static hedges Complete static hedge Fully passive risk management strategy Credit risk measured in EL CDS principal = Debt principal Protection period = RM To remove completely the credit risk arising from the principal Partial static hedge Credit risk measured in EL CDS principal < Debt principal Protection period = RM To remove the credit risk arising from certain part of the principal Example 11.2 Example 11.3
13.
Copyright © 2018
CapitaLogic Limited 13 Dynamic hedge Fully active risk management strategy Credit risk measured in 1-year EL Protection period = 1 year CDS principal < Debt principal To bring the credit risk of the principal below the tolerance level Lender to review and control the credit risk at least annually More cost effective More effort on active risk management Example 11.4
14.
Lower and upper
bounds of the joint PD Lower bound PD1 × PD2 Upper bound Copyright © 2018 CapitaLogic Limited 14 -1 -1 1 2 2 2 Φ PD Φ PD 22 -¥ -¥ 1 2 1 x + y - 2xy × CCC exp - dxdy 2 1 - CCC2π 1 - CCC where CCC = CCC × CCC Example 11.5
15.
Copyright © 2018
CapitaLogic Limited 15 Expected protection Factor Impact to expected protection Variation after origination Principal + No LGD + Moderate PD + Material Protection period + Decreasing gradually Protection period Expected protection = Principal × LGD × 1 - 1 - PD
16.
Copyright © 2018
CapitaLogic Limited 16 CDS spread CDS spread The annualized premium rate which results a zero value for the single name CDS Lower credit quality => more default protection => higher regular premium => higher CDS spread Regular premium amount × Premium frequency CDS spread = × 100% Principal
17.
Copyright © 2018
CapitaLogic Limited 17 Credit risk Protection buyer – long position No credit risk Protection seller – short position Protection period Protection period EL = Expected protection = Principal × LGD × 1 - 1 - PD 1-year EL = Principal × LGD × Min PD, 1 - 1 - PD
18.
Copyright © 2018
CapitaLogic Limited 18 Outline Single name CDS Binary CDS Basket CDS Portfolio CDS Appendices
19.
Copyright © 2018
CapitaLogic Limited 19 Binary CDS To speculate on the default of a reference institution Protection buyer Protection seller Principal × 60 bps every quarter Default protection = Principal
20.
Copyright © 2018
CapitaLogic Limited 20 Cash flows Outflows When the reference institution survives Regular premium at arrear quarterly When the reference institution defaults Accrued premium Inflows Upon default Principal Cash settlement Premium rate Principal × Premium frequency No. of days since last premium day × No. of days between last and next premium days
21.
Copyright © 2018
CapitaLogic Limited 21 Expected protection Factor Impact to expected protection Variation after origination Principal + No PD + Material Protection period + Decreasing gradually Protection period Expected protection = Principal × 1 - 1 - PD
22.
Copyright © 2018
CapitaLogic Limited 22 Credit risk Protection buyer – long position No credit risk Protection seller – short position Protection period Protection period EL = Expected protection = Principal × 1 - 1 - PD 1-year EL = Principal × Min PD, 1 - 1 - PD
23.
Copyright © 2018
CapitaLogic Limited 23 Outline Single name CDS Binary CDS Basket CDS Portfolio CDS Appendices
24.
Copyright © 2018
CapitaLogic Limited 24 Three single name CDSs My basket USD 100mn GM US 3-year bond USD 100mn Three Deer China 3-year bond USD 100mn Northern Rock UK 3-year bond Hedging strategy Single name CDS on GM US 3-year bond with principal USD 100mn Single name CDS on Three Deer China 3-year bond with principal USD 100mn Single name CDS on Northern Rock UK 3-year bond with principal USD 100mn Advantages vs disadvantages Principals hedge perfectly Expensive
25.
Copyright © 2018
CapitaLogic Limited 25 1st-to-default CDS Cash outflows Protection buyer pays a regular premium Cash inflows If GM US defaults first, protection buyer pays the accrued premium and receives a default protection as if the 1TD CDS is a single name CDS with GM US as the reference debt If Three Deer China defaults first, protection buyer pays the accrued premium and receives a default protection as if the 1TD CDS is a single name CDS with Three Deer China as the reference debt If Northern Rock UK defaults first, protection buyer pays the accrued premium and receives a default protection as if the 1TD CDS is a single name CDS with Northern Rock UK as the reference debt Advantages vs disadvantages Less expensive than three single name CDSs No protection to the second and last defaults Example 11.6
26.
Copyright © 2018
CapitaLogic Limited 26 2nd-to-default CDS Cash outflows If no debt defaults, protection buyer pays the regular premium If any one debt defaults, protection buyer continues to pay the same regular premium Cash inflows If two debts default, protection buyer pays the accrued premium and receives a default protection as if the 2TD CDS is a single name CDS with the second defaulted debt as the reference debt Advantages vs disadvantages Less expensive than three single name CDSs No protection to the first and last defaults
27.
Copyright © 2018
CapitaLogic Limited 27 Last-to-default CDS Cash outflows If no debt defaults, protection buyer pays the regular premium If any one debt defaults, protection buyer continues to pay the same regular premium If any two debts default, protection buyer continues to pay the same regular premium Cash inflows If all three debt defaults, protection buyer pays the accrued premium and receives a default protection as if the LTD CDS is a single name CDS with the last defaulted debt as the reference debt Advantages vs disadvantages Less expensive than three single name CDSs No protection to the first and second defaults
28.
Copyright © 2018
CapitaLogic Limited 28 Nth-to-default CDS My basket USD 100mn × Q reference debts (Q > N) Cash outflows If no debt defaults, protection buyer pays the regular premium If any one debt defaults, protection buyer continues to pay the same regular premium If any N-1 debts default, protection buyer continues to pay the same regular premium Cash inflows If the Nth debt defaults, protection buyer pays the accrued premium and receives a default protection as if the NTD CDS is a single name CDS with the Nth defaulted debt as the reference debt Example 11.7
29.
Copyright © 2018
CapitaLogic Limited 29 Cash inflows In physical settlement, protection buyer Delivers the reference debt to the protection seller Receives the principal in full from the protection seller In cash settlement, protection buyer Receives default protection from the protection seller Principal × LGD Executes the debt collection to recover (Principal + Accrued interest) ) × (1 - LGD)
30.
Copyright © 2018
CapitaLogic Limited 30 Expected protection Category Factor Impact to expected protection Variation after origination Reference debt Principal + No LGD + Moderate PD + Material Protection period + Decreasing gradually Basket Protection order - No Basket size + for early protection - for late protection Mild Default dependency - for early protection + for late protection Moderate
31.
Copyright © 2018
CapitaLogic Limited 31 Credit risk Protection buyer – long position No credit risk Protection seller – short position EL or 1-year EL with Monte Carlo simulation
32.
Copyright © 2018
CapitaLogic Limited 32 Outline Single name CDS Binary CDS Basket CDS Portfolio CDS Appendices
33.
Copyright © 2018
CapitaLogic Limited 33 A less uniform portfolio My basket USD 100mn GM US 3-year bond USD 120mn Three Deer China 3-year bond USD 80mn Northern Rock UK 3-year bond Hedging strategy Single name CDS on USD 100mn GM US 3-year bond Single name CDS on USD 120mn Three Deer China 3-year bond Single name CDS on USD 80mn Northern Rock UK 3-year bond Advantages vs disadvantages Principals hedge perfectly Expensive
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CapitaLogic Limited 34 Portfolio CDS – First USD 100mn principal Cash outflows If no debt defaults, protection buyer pays a regular premium Cash inflows If GM US defaults first, protection buyer pays the accrued premium and receives a default protection as if the portfolio CDS is a single name CDS of principal USD 100mn with GM US as the reference debt. The portfolio CDS terminates after the protection payment If Three Deer China defaults first, protection buyer pays the accrued premium and receives a default protection as if the portfolio CDS is a single name CDS of principal USD 100mn with Three Deer China as the reference debt. The portfolio CDS terminates after the protection payment If Northern Rock UK defaults first, protection buyer pays the accrued premium and receives a default protection as if the portfolio CDS is a single name CDS of principal USD 80mn with Northern Rock UK as the reference debt. The portfolio CDS continues to works as a USD 20mn portfolio CDS Advantages vs disadvantages Less expensive No protection beyond the fixed amount of principal
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CapitaLogic Limited 35 Tranching of a debt portfolio Example 11.8
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CapitaLogic Limited 36 Cash outflows When the tranche survives fully Regular premium at arrear quarterly When the tranche defaults partially Accrued premium Regular premium reduced to Survived tranche principal Initial regular premium × Total tranche principal
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CapitaLogic Limited 37 Cash inflows In physical settlement, protection buyer Delivers the reference debt to the protection seller Receives the principal in full from the protection seller In cash settlement, protection buyer Receives default protection from the protection seller Principal × LGD Executes the debt collection to recover (Principal + Accrued interest) ) × (1 - LGD) Example 11.9 Example 11.10
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CapitaLogic Limited 38 Expected protection Category Factor Impact to expected protection Variation after origination Portfolio Portfolio principal + No LGD + Moderate PD + Material Protection period + Decreasing gradually Concentration of debts -for small attachment point + for large attachment point Mild Default dependency Moderate Tranche PAP - No PDP + No
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CapitaLogic Limited 39 Credit risk Protection buyer – long position No credit risk Protection seller – short position Neither EL, 1-year EL nor XCL serves as a valid credit risk measure EL, 1-year EL and XCL fail to incorporate the effect from attachment and detachment points
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CapitaLogic Limited 40 Outline Single name CDS Binary CDS Basket CDS Portfolio CDS Appendices
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CapitaLogic Limited 41 Non-standard single name CDS Standard Protection to principal only Non-standard – EAD Protection to EAD = Principal + Accrued interest Non-standard – amount and schedule Protection to amounts and schedule
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CapitaLogic Limited 42 CDS trading A protection buyer reverses an existing CDS with the protection seller At origination Present value of expected protection = Present value of expected premiums After origination Expected premiums remain fixed Expected protection varies subject to credit quality of the reference debt/portfolio CDS value = Present value of expected protection - Present value of expected premiums
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CapitaLogic Limited 43 Upfront fee Absolute value of the CDS value Protection buyer receive from protection seller when the present value of expected protection is higher than the present value of expected premiums Protection buyer pay to protection seller when the present value of expected protection is lower than the present value of expected premiums