11.2 credit default swaps

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

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.

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

Outline
 Single name CDS
 Binary CDS
 Basket CDS
 Portfolio CDS
 Appendices

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

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



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

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



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

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)

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



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

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

Lower and upper bounds
of the joint PD
 Lower bound
PD1 × PD2
 Upper bound
 
  -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

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 
 

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

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
 
 
 
 

Outline
 Single name CDS
 Binary CDS
 Basket CDS
 Portfolio CDS
 Appendices

Binary CDS
 To speculate on the default of a reference
institution
Protection
buyer
Protection
seller
Principal × 60 bps
every quarter
Default protection
= Principal

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

Expected protection
Factor
Impact to
expected protection
Variation after
origination
Principal + No
PD + Material
 
Protection period
Expected protection = Principal × 1 - 1 - PD 
 

Credit risk
 No credit risk
 
 
Protection period
Protection period
EL = Expected protection
= Principal × 1 - 1 - PD
1-year EL = Principal × Min PD, 1 - 1 - PD
 
 
 
 

Outline
 Single name CDS
 Binary CDS
 Basket CDS
 Portfolio CDS
 Appendices

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

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
 Less expensive than three single name CDSs
 No protection to the second and last defaults
Example 11.6

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
 No protection to the first and last defaults

Last-to-default CDS
 Cash outflows
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
 No protection to the first and second defaults

Nth-to-default CDS
 My basket
 USD 100mn × Q reference debts (Q > N)
 Cash outflows
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

Cash inflows
 Receives the principal in full from the protection seller
 Receives default protection from the protection seller

Expected protection
Category Factor
Impact to
expected protection
Variation after
origination
Reference debt
Principal + No
LGD + Moderate
PD + Material
Basket
Protection order - No
Basket size
+ for early protection
- for late protection
Mild
Default dependency
- for early protection
+ for late protection
Moderate

Credit risk
 No credit risk
 EL or 1-year EL with Monte Carlo simulation

Outline
 Single name CDS
 Binary CDS
 Basket CDS
 Portfolio CDS
 Appendices

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
 Principals hedge perfectly
 Expensive

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
 Less expensive
 No protection beyond the fixed amount of principal

Tranching of a debt portfolio
Example 11.8

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

Cash inflows
 Receives the principal in full from the protection seller
 Receives default protection from the protection seller
Example 11.9
Example 11.10

Expected protection
Category Factor
Impact to
expected protection
Variation after
origination
Portfolio
Portfolio principal + No
LGD + Moderate
PD + Material
Concentration of debts -for small
attachment point
+ for large
attachment point
Mild
Default dependency Moderate
Tranche
PAP - No
PDP + No

Credit risk
 No credit risk
 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

Outline
 Single name CDS
 Binary CDS
 Basket CDS
 Portfolio CDS
 Appendices

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

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

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

11.2 credit default swaps

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