The Opacity of the CDS Basis

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This presentation explores the evaluation issues associated with Credit Default Swap Basis trades.

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The Opacity of the CDS Basis

  1. 1. The Opacity of the CDS Basis Gaetan Lion March 30, 2012 1
  2. 2. Why is this an important topic? 2
  3. 3. CDS is a huge BusinessNominal CDS contract outstanding exceeds World GNP. 3
  4. 4. Two CDS Buyers have made a huge amount of money Michael Burry, the “one eyed surgeon”, will create the first CDS on Subprime CDOs with Greg Lippman from Deutsche Bank in 2005. Dr. Burry will make $100 million for himself and about $700 million for his clients. John Paulson enters this CDS on Subprime CDOs market in 2006. He will make $7 billion for himself and $23 billion for his hedge fund clients. 4
  5. 5. Several CDS Sellers have lost a huge amountAlso, European banks who invested in Synthetic CDOswere by definition CDS sellers. They were the ones on theother side of the trades who lost money to Michael Berryand John Paulson. 5
  6. 6. CDS is a great source of Credit Risk InformationVery Different Credit Risk for major US Banks. 6
  7. 7. People are focusing on the CDS BasisCDS Basis = CDS premium – Bond Credit Spread. 7
  8. 8. Some Institutions have incurred large losses on CDS Basis trades In early 2009, Merril Lynch, Deutsche Bank and several hedge funds did lose several $billions on CDS basis trade commonly known as Negative Basis trade*. *When the CDS premium is lower than the Bond spread, a trader buys the Bond (ie. Credit Spread 4%) and buys the CDS (pays premium 3%) and earns a spread (1%) between the two… ideally anyway?! 8
  9. 9. CDS & CDS Basis Introduction 9
  10. 10. CDS introThe CDS buyer (the The CDS sellerinsured) pays a credit sells creditinsurance premium on insurance againsta specific bond issuer, the default of acovering the latter’s specific bond issuercredit risk for the and receives aduration of the CDS premium from thecontract. CDS buyer.If the bond issuerdefaults, the CDSseller (the insurer)repays the CDSbuyer the par valueof the bond. 10
  11. 11. A CDS is a Put Option on the Bond Par value CDS Buyer pays a premium and "Puts" the Bond back to the Buyer in case of default. CDS value positive + 0% Repayment prob. or (1 - Default prob.) 100% CDS Seller receives premium and repays Bond par value to the Buyer in case of default. CDS value positive + Premium 0% Repayment prob. or (1 - Default prob.) 100% CDS value negative - 11
  12. 12. Change in Default Probability impacts CDS valueCDS Buyer pays a premium and "Puts" the Bond back to the Buyer in case of default. Incr. in Default prob. Decrease in Default prob. CDS value positive When the Default probability + increases, the CDS value rises and the CDS Buyer’s CDS 0% Repayment prob. or (1 - Default prob.) 100% Put is in the money. He can value negative resell it at a profit. -CDS Seller receives premium and repays Bond par value to the Buyer in case of default. CDS Incr. in Default prob. Decrease in Default prob. value positive + Premium 0% Repayment prob. or (1 - Default prob.) 100% CDS value negative - 12
  13. 13. CDS BasisCDS Basis = CDS premium – Bond Spread over Rfr. In theory, under the no-arbitrage principle, the CDS Basis would equal zero. In reality, the CDS Basis is always away from zero, either positive or negative.Positive Basis: CDS > Bond SpreadNegative Basis: CDS < Bond Spread 13
  14. 14. Choices of Bond Spreads That’s when it gets foggy (opaque) 14
  15. 15. Clarity vs OpacityClarity: A CDS quote is crystal clear. Thepremium is expressed in basis points perannum.Opacity: the Bond spread is calculated. And, there are several underlying issues.1) What is the appropriate discount rate (Rfr)?2) What is the appropriate Spread calculations?Different Spread calculations can result in theCDS Basis changing sign! 15
  16. 16. The Evolution of Bond Spread Calculations 1 Bond Spread: Bond Yield - Treasuries of same term. 2 Bond Spread: Bond Yield - Treasuries tax adjusted Adjustment for Treasuries being State tax exempt. 3 Asset Swap Spread (ASW): Asset Swap Rate - LIBOR Disaggregates Credit Risk from Interest Rate Risk. Takes into account the term structure of interest rates. 4 Z-Spread or Zero Coupon Spread. Uses Treasuries instead of LIBOR to construct term structure of interest rates. 5 I-Spread or Interpolated Spread. Uses interpolated Treasury rates. A variation of the Z-Spread. 6 Option Adjusted Spread (OAS) Takes into account the term structure of probabilities of default by constructing a survival probability curve. Legend Not the main Spread established benchmark anymore. Currently most common ones. Quoted on Bloomberg. 16
  17. 17. Bond Spread vs ASW, Z-Spread, I-Spread Difference in Spread Calculation 12% Bond Spread ASW, Z-Spread, and I-Spread 10% 8% Credit Spread 6% 4% Rfr3 Rfr Rfr2 2% Rfr1 0% Constant rate 1 2 Period 1 3 Period 2 4 Period 3 5Within the Bond Spread method, cash flows are discounted at the same rate.Within the other Spreads, cash flows discounting reflects the term structure ofinterest rates. Notice that the Credit Spread component is constant within either 17method. That’s even though the derived Credit Spread may be different.
  18. 18. Bond Spread vs OAS Difference in Spread Calculation 14% OAS 12% Bond Spread 10% CS3 8% Credit Spread CS2 6% (CS) Rfr3 4% CS1 Rfr Rfr2 2% Rfr1 0% Constant rate 1 2 Period 1 3 Period 2 4 Period 3 5The Option Adjusted Spread (OAS) method of discounting capturesboth the term structure of interest rates and credit risk or defaults. Theyare low in Period 1 and continue rising in all future periods. The OAS isthe Credit Spread that corresponds to the discounted PV weighted of allthe various Credit Spreads (CS1, CS2, CS3, etc…). 18
  19. 19. The Asset Swap Spread 7%Fixed rate 7% Bd. Investor I.R. Swap bond Counterparty LIBOR + 3% (ASW)An Investor invests in a fixed rate bond paying 7%. To hedge hisinterest rate risk, he enters into an Interest Rate Swap with acounterparty and passes on the 7% fixed rate payment in exchange forfloating rate LIBOR + 3%. The 3% is the Asset Swap Spread (ASW).PV of 7% fixed rate payments = PV LIBOR + 3% payments 19
  20. 20. Asset Swap with a CDS 7% Fixed rate 7% Bd. Investor I.R. Swap bond CDS Buyer Counterparty LIBOR + 3% (ASW) CDS premium 3% CDS SellerThe Bond Investor has already hedged his interest rate risk. He nowwants to hedge his credit risk. He buys a CDS on the bond issuer andpays a CDS Seller a premium.Now, we can define the CDS Basis: CDS premium – ASW.In this case it is zero. Net result, Investor earns Libor. 20
  21. 21. Asset Swap with CDS at Default 7% Bd. Investor I.R. Swap CDS Buyer Counterparty LIBOR + 3% (ASW) Puts pays Bd Bonds Par valueBond issuer. PutsCh 11 or 7: Bonds CDS Reorg./ Seller RecoveryLiquidationNote that for the initial Bond Investor the Interest Rate Swap is still going on!He can unwind that swap, but he is now exposed to a mark-to-market risk onthis IR swap. While the Bond issuer was solvent, the Bond Investor’s interestrate risk was hedged. But, upon default it is not. 21
  22. 22. Factors affecting the CDS Basis 22
  23. 23. Basic Economic PrinciplesAny factor increasing the risk of a CDS Seller relative to theASW will increase the CDS basis (and vice versa).Any factor increasing the return of a CDS Seller relative tothe ASW will decrease the CDS basis (and vice versa).Any factor boosting the Demand for CDS (Seller side)relative to the ASW will increase the CDS basis (and viceversa).Any factor boosting the Supply for CDS (Seller side) relativeto the ASW will decrease the CDS basis (and vice versa).Those concepts of Risk, Return, Demand, Supply areuniversal and affect all insurance products (car insurance,etc…). 23
  24. 24. Some Factors affecting the CDS Basis• Change in interest rates (+ or -);• Funding considerations (+ or -);• Relative liquidity (bid & ask spread) in both markets (+ or -);• Synthetic CDO Issuance, Loan syndication, etc…: It boosts Seller Supply (-);• Relative counterparty risk considerations (CDS Seller credit quality vs Interest Rate Swap counterparty risk);• Difficulty in shorting bonds: when CDS basis > 0, arbitrage of selling the CDS and selling the bond is rarely feasible (+).• CDS credit event trigger definition is often broader than for the Bond. It increases the CDS Seller risk (+). 24
  25. 25. Change in Interest Rates1. At time of default, the loss of the CDS Seller is equal to Par value of the bond minus recovery. The loss of bondholder is Market value of the bond minus recovery. If interest rates have risen: Market value < Par value; and CDS loss > Bondholder loss. And, vice versa. This affects the CDS basis accordingly.5. Change in interest rates also affect the mark-to-market value of the embedded interest rate swap within the asset swap structure (ASW). Remember, the interest rate swap survives after default!6. Change in Repo rates affects ability to short a bond. But, it is really difficult to short a bond anyway. 25
  26. 26. Funding ConsiderationsWhen you invest in the Credit risk of acompany by purchasing a bond you paymoney. If you invest in Credit risk by selling aCDS you actually receive money (premium).Thus, changing capital market conditions affectCDS and Bonds differently. 26
  27. 27. An Arbitrage Opportunity Decision Tree Major Fog Warning 27
  28. 28. The Basic Decision Tree CDS > OAS No arbitrageCDS < ASW CDS < OAS Negative basis trade: buy Bond & buy CDS CDS > OAS No arbitrageCDS > ASW CDS < OAS Negative basis trade: buy Bond & buy CDS You can’t rely on just the Asset Swap Spread (ASW) or its equivalents (Z-Spread, I-Spread). You have to look at the Option Adjusted Spread (OAS). 28
  29. 29. The OAS Decision Tree > Bid & Ask Spreads Negative basis trade[CDS < OAS] < Bid & Ask Spreads No arbitrage The absolute value of the CDS negative basis has to be greater than related Bid & Ask spreads. Otherwise, the transaction costs eliminate the arbitrage opportunity. 29
  30. 30. Opacity?! OAS Model underestimated factors Negative basis trade loses money[CDS < OAS]>Bid-Ask OAS Model got it right Negative basis trade is profitable The mentioned factors are the ones affecting the CDS Basis described earlier. Several are qualitative in nature and challenging to predict and quantify precisely. It is uncertain whether such OAS models can provide reliable information. This questions the viability of arbitrage opportunities. [CDS < OAS]>Bid-Ask Arbitrage opportunity or disaster? 30
  31. 31. Appendix Section 31
  32. 32. Working Papers Findings Working papers analyzing the CDS Basis (using mainly the I-Spread as proxy for Bond Spread) through various time periods from January 1999 through December 2005 have found the following:2) CDS Basis: the Average CDS basis is very small and typically positive (ranging from – 2 bp to 16 bp). The Median is even smaller (0 to 7 bp). The CDS Basis can depend on time, place (US vs Europe), and company.3) Price discovery: using sophisticated methods* they found that at times CDS tend to lead bonds spreads. It is more so in the US, and less so in Europe. *Cointegration, Granger Causality, VECM methods. 32
  33. 33. Morgan Stanley CDS vs Bond SpreadBetween 8/31 and 11/24/2011 the Bond Spread (Bond Yield – Treasury) has beenmuch higher than the CDS. For other time periods, the reverse may have been 33observable.
  34. 34. CDS always lead in both the decline and increase in credit risk untilconvergence in early 2010. 34
  35. 35. As the title suggests, Italian bond spreads take the lead in May 2011. 35
  36. 36. Here Spain CDS clearly lead bond spread for an entire year, until the 36two converge by second half of 2010.
  37. 37. Except for a couple of quarters in 2009, Belgian CDS are chronicallyhigher than Belgian bond spreads. 37
  38. 38. For Further Study read this book Moorad Choudhry, the author, is Head of Treasury at Corporate Banking Division, Royal Bank of Scotland, a Visiting Economics Professor at London Metropolitan University, a renowned expert on CDS, and an avid cricket player. 38

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