Credit Default Swaps

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Credit Default Swaps

• A Credit Default Swap (CDS) is a contract in
  which the writer offers the buyer protection
  against a credit event in a reference name for a
  specified period of time in return for a premium
  payment.
• Typical CDS cashflows
• The contract pays par in return for 100 nominal
  of debt if the reference name suffers a credit
  event before the maturity of the deal.
• The buyer pays a premium quarterly in arrears.

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CDS Structure
Pre-default
Quarterly premium in arrears
Protection Buyer
Protection Seller
Post-default
Defaulted debt of reference name
Protection Buyer
Protection Seller
Par less fraction of premium
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CDS Example
Pre-default
314.486 bps quarterly in arrears
Protection Buyer
Protection Seller
Post-default
1,000,000 Par GMAC
Protection Buyer
Protection Seller
1,000,000 plus fraction of premium
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Par Asset Swap Example
Market
Fixed Coupon Credit Bond
CashBond Dirty Price
Floating
Floating payments par at maturity
Interest Rate Swap Desk
AS Trading Desk
Investor
Par
Fixed
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CDS - Asset Swap Hedge
Market
Fixed Coupon Credit Bond
CashBond Dirty Price
Quarterly premium in arrears and defaulted debt
upon default
Floating
Floating payments par at maturity
Interest Rate Swap Desk
AS Trading Desk
Investor/ Protection Buyer
Protection Seller
Par
Fixed
Par less fraction of premium upon default
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CDS - Asset Swap Hedge Example
Market
10,000,000 Par GMAC 5 5/8s of 5/15/2009
9,300,00042,187.509,342,187.50
Floating 3M LIBOR273.7bps
Floating 3M LIBOR256.8 bps
314.486 bps quarterly in arrears
Interest Rate Swap Desk
AS Trading Desk
Investor/ Protection Buyer
Protection Seller
10,000,000 par of GMAC debt on default event
Fixed 5.45232 semi-annual
10,000,000 initially
10,000,000 less partial premium on default event
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Initial Cashflows
Market
10,000,000 Par GMAC 5 5/8s of 5/15/2009
9,300,00042,187.509,342,187.50
Interest Rate Swap Desk
AS Trading Desk
Investor/ Protection Buyer
Protection Seller
719,881
10,000,000 initially
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Typical Periodic Cashflows
Market
281,250 semi-annually
LIBOR68,425 quarterly (approx. 204,200)
LIBOR64,200 quarterly (approx. 200,000)
79,495 quarterly
Interest Rate Swap Desk
AS Trading Desk
Investor/ Protection Buyer
Protection Seller
272,616 semi-annually
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Cashflows on Default
Market
10,000,000 Par defaulted GMAC 5 5/8s of 5/15/2009
10,000,000 Par defaulted GMAC 5 5/8s of
5/15/2009 or similar
Interest Rate Swap Desk
AS Trading Desk
Investor/ Protection Buyer
Protection Seller
10,000,000 less partial premium
Unwind IR swap
Unwind IR swap
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Is the Protection Buyer Hedged?

• Upon default, the protection buyer receives 10m
  from the protection seller and (assuming 40
  recovery) delivers defaulted debt worth 4m. At
  the inception of the contract, the GMAC note was
  only worth 9.3m. So the buyer receives a net of
  6m from the CDS, has really lost only
  9.3-45.3m. So the buyer has too much CDS. The
  correct hedge ratio is given by
• In this case the protection buyer should buy 10m
  x (.93-.4)/(1-.4)8.9m notional CDS to be
  hedged.

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CDS Basis

• A number of factors observed in the market serve
  to make the price of credit risk that has been
  established synthetically using credit default
  swaps to differ from its price as traded in the
  cash market using asset swaps.
• Identifying such differences gives rise to
  arbitrage opportunities that may be exploited by
  basis trading in the cash and derivative markets.
  This in known as trading the credit default basis
  and involves either buying the cash bond and
  buying a CDS on this bond, or selling the cash
  bond and selling a CDS on the bond.
• The difference between the synthetic credit risk
  premium and the cash market premium is known as
  the basis.
  CDS Premium Z-Spread basis.

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CDS Basis
Market
Basis314.486-291.922.586
10,000,000 Par GMAC 5 5/8s of 5/15/2009 Z-Spread
291.9
930,0004,218.75934,218.75
Floating 3M LIBOR273.7bps
Floating 3M LIBOR256.8 bps
314.486 bps quarterly in arrears
Interest Rate Swap Desk
AS Trading Desk
Investor/ Protection Buyer
Protection Seller
Fixed 5.45232 semi-annual
1,000,000
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CDS Basis

• The basis is usually positive, occasionally
  negative, and arises from a combination of
  several factors, including
• Bond identity The bondholder is aware of the
  exact issue that they are holding in the event of
  default however, default swap sellers may
  receive potentially any bond from a basket of
  deliverable instruments that rank pari passu with
  the cash asset. This is the delivery option held
  by the protection buyer.
• Depending on the precise reference credit, the
  CDS may be more liquid than the cash bond,
  resulting in a lower CDS price, or less liquid
  than the bond, resulting in a higher price.