Credit Risk Management Using Swaps

8/11/2019 Credit Risk Management Using Swaps

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Credit Risk ManagementUsing Swaps


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1. Credit Default Swaps (CDS)

11/04/2013Bushra Naqvi, PhD, FRM 2


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Credit Default Swaps

A CDS is the most popular form ofprotectionsagainst default.

A swap designed to transferthe credit exposure

of fixed income products between parties. A

credit default swap is also referred to as acredit derivative contract.



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Credit Default Swaps (CDS)

Its an agreementwhere the purchaser of the swapmakespaymentsup until the maturity date of a

contract, or until a credit eventoccurs.

Payments are made to the seller of the swap in

arrears on a quarterly, semi-annually or annual

basis. In return, the seller agrees topay off a

third party debt if this party defaultson the

loan.



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Credit Default Swaps

The buyerof a credit default swap receives creditprotection, whereas the sellerof the swap

guarantees the credit worthinessof the debtsecurity. In doing so, the risk of default is

transferred from the holder of the fixed incomesecurity to the seller of the swap. A CDS is

considered an insurance against non-payment.

A buyer of a CDS might be speculating on thepossibility that the third party will indeed

default.

It was invented by Blythe MastersfromJP Morganin1994.



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Credit Default Swaps: Terms

Some of the most important terms to remember when dealing withCDSs are:

Reference Entity

The reference entity is the entity (or company) upon which defaultprotection is bought or sold. The reference entity may or may not beinvolved directly with the specific CDS transaction.



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Credit Event

A credit event is defined as either technical default based on a ratiocalculation or actual default if the firm misses a coupon or principalpayment. Credit events will trigger payments to flow across CDScounterparties.



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Reference Obligation

When a CDS is bought or sold on a reference entity, the purchaser ofthe CDShas the right to sell a bond issued by the reference entity tothe seller of the CDS. The bond sold is called the reference obligation.



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CDS Notional Principal

The par value of the reference obligation to be sold with a CDS.

CDS Spread

The amount paid per year by the buyer of the CDS as a percentage ofnotional principal is called the CDS spread and is usually expressed inbasis points.



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CDS Settlements



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CDS Example

Suppose

Global Bank owns a bond issued by KKUCorporation with a par value of $50 million.

Global would like to protect its position againstcredit risk and enters into a CDS with BerndtFinancial.

Swap is initiated on July 1, 2006 and terms of theCDS call for Global Bank to make payment of 80basis points to Berndt Financial based on thenotional principal of $50 million for a period of 4years, or until a credit event occurs.



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CDS Example



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Different Aspects of CDS Reference Name

Instead of assets, CDSs are most often based on a

reference name: the legal entity corresponding to aspecific issue or obligor

Ownership

In a CDS, protection buyer does not need to own thereference asset; does not need to have an insurable

interest (Moral Hazard) Default Probability

A CDS transaction contains a greater potential for oneparty to possess more information regarding defaultprobabilities than other parties and therefore have amore detailed understanding of the future prospects for a

particular company (Information asymmetry)



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Valuation of a CDS

The goal of CDS valuation is to determine the valueof the mid-market (i.e., average of bid and askprices) CDS spreadon the reference entity.

There arefoursteps in calculating CDS spread:

1. Calculate the PV of the expected payments

2. Calculate the PV of the expected payoff in the event ofdefault

3. Calculate the PV of the accrual payment (if any) in theevent of default

4. Calculate the CDS spread



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Valuation of a CDS

Example

Vona Incorporated enters into a 4-year CDS withMoore Insurance to hedge the credit risk of $200million bond issued by WK Corporation.

The probability of PWK Corp. (the reference entity)defaulting during a year, conditional on no earlierdefault is 3%

Assuming payments are made once a year, at theend of the year. The risk-free rate is 6% per yearcompounded continuously and recovery rate in theevent of default is 30%. Moreover, defaults are alsoassumes too be occurring halfway through a year

Find the CDS spread? 11/04/2013Bushra Naqvi, PhD, FRM 17


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Valuation of a CDS

Find

Default and Survival Probabilities of PWK Corp. PV of the expected payments for 4-years

PV of the expected payoffs in the event ofdefault (assume default occurs halfway througha year)

PV of accrual payment (as defaults areassumed to be occurring halfway through ayear)

Calculate the CDS Spread



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Default and Survival Probabilities ofPWK Corp.



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PV of the Expected Payments



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PV of the Expected Payoffs



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PV of the Expected Payoffs



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PV of Accrual Payment



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CDS Spread

PV of Expected Payments

3.2068s + 0.0511s = 3.2579s

PV of Expected payoffs

0.0716

Solving for s

3.2579s = 0.0716

s = 0.0220 or 2.20%



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Basket CDS / Portfolio CDS

A basket CDS is a CDS on a portfolio of assets

where the payoff occurs based on apredetermined credit event.

The most common is afirst-to-default swap,which makes a payoff when the first referenceentity in he basket defaults. Other basketCDSs are usually referred to as nth-to-defaultCDSs, where the payoff occurs when the nthdefault occurs in a portfolio of companies.



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Portfolio CDS



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Portfolio CDS

The most important factor is determining thespread for a basket CDS is the defaultcorrelationof the reference entities in thebasket.

Lowerthe correlation among entities, high the

probability of one or more defaults duringspecified period but lower the probability ofmaximum defaults. Moreover, lower the valueof nth-to-defaultas compared tofirst-to-default.



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Portfolio CDS

Higherthe correlation, the probability ofmultiple defaults also increases, thusincreasing the value of an nth-to-defaultCDS.

Perfectcorrelation indicates either nodefaults or all default situation, which means

no difference in the value of first-to-defaultand nth-to-default CDSs.



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2. Credit Linked Notes (CLNs)


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Credit Linked Notes


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Credit Linked Notes


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3. Collateralized Debt Obligations

(CDOs)


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Securitization

Securitization: Role of Participants


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p


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Collateralized Debt Obligations

A particular type of ABS is a Collateralized Debt Obligations(CDO). This is anABS where the underlying assets arefixed-income securities.

Cash CDOs Structure


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Cas C Os St uctu e


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Collateral Used in CDOs


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Tranches


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Factors for the Growth of CDO Market

1. CDOs gives banks an effective way to manage credit risk2. CDOs gives investors access to a diversifies pool of risky credit assets

3. Credit Tranching allows investors to select specific credit risk exposure

4. Fees collected by asset managers for managing CDOs structure and byunderwriters for selling tranches to investors.


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Types of CDOs


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BS CDOs vs. Arbitrage CDOs


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Synthetic CDOs

Synthetic CDOs Structure


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Comparison

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Credit Risk Management Using Swaps