focus oncredit default swap basics v501

1、Focus on : Credit Default Swap Basics()Materials contributed by Julia Zhu. Last updated on 11th Aug 2008 by Vincent Chia.Credit Default Swap #4448158, CDS Analysis #4447054, Markit Data v501 #4450174 v510 #44503532Credit Default Swap BasicsAgenda1.What is a Credit Default Swap, CDS ?2.How to get ind

2、icative data ?3.How to price and analyse a CDS ?4.Application of CDS data5.ConclusionAppendix :other Reuters Credit modelsA.understand Reuters Instrument Code for CDS Credit Default Swap Basics 4Credit Default Swap Basics1.1 What is Credit Risk ?Credit risk is the risk of loss due to a Debtors non-p

3、ayment of a Loan or other line of Credit, either the Principal or Interest (Coupon) or both.In this case, we refer to the Credit Risk faced by Owner of Debt, Lenders to Business, or more accurately, Holders of Corporate Bonds.To reduce or strip out Credit risk, Risk Manager may :Take CollateralMake

4、loss provisionsActively manage the Credit Risk Exposure or use Credit Derivatives :1.Credit Default Swaps and others5Credit Default Swap BasicsA CDS is a Bilateral Contract under which two Counterparties agree to isolate and separately trade the Credit Risk of at least one Third-Party Reference Enti

5、ty. Under a CDS agreement, a Protection Buyer pays a periodic fee or premium to a Protection Seller in exchange for a contingent payment by the Protection Seller upon a Credit Event happening in the Reference Entity. 1.2.1 What is a Credit Default Swap, CDS ? TimeProtection Buyere.g. BanksProtection

6、 Sellere.g. Hedge FundsInsurers &Reinsurerscashflow of CDS premium (quarterly)Fixed LegPays CDS premium quarterly6Credit Default Swap BasicsHedging PerspectiveCDS resemble an Insurance Policy, as they can be used by Debt Owners to hedge against Credit Events. Speculative PerspectiveHowever, beca

7、use there is no requirement to actually hold any Asset or suffer a Loss, CDS can be used to speculate on changes in Credit Spread.1.2.2 CDS vs Car Insurance Policy7Credit Default Swap Basics1.2.3 Trading CDS and Protect Asset via CDSTime5YInitial Risky Curve5Y CorpBond Price Term(maturity) yield %Ri

8、sky Curve after a credit event occurred. $100 $90 credit spread widensBad news onthe CorporateProfit or Lossfor longing a 5Y CDSor shorting Risk + Credit spreadCoupons5YNote :CDS behaves like a Put option on Bonds priceor a Call option on Bonds yield.8Credit Default Swap BasicsIn a CDS, the protecti

9、on buyer pays a Premium in periodic installments in exchange for a termination payment if a Credit Event occurs for a given Reference Entity (Reference Name or Signature).The size of the CDS premium is called the swap rate.1.2.4 CDS premium or CDS swap rate or CDS spreadTimeDefault !Protection Buyer

10、s perspective9Credit Default Swap Basics1.2.5 European Style CDSProtection Sellers perspective10Credit Default Swap Basics1.2.6 American Style CDS (more popular)Protection Sellers perspectiveaccruedinterest11Credit Default Swap Basics1.3.1 What is a Credit Event ?ISDA : International Swaps and Deriv

11、atives AssociationThe ISDA 2003 defined Credit Events are :1.Bankruptcy (insolvency)2.Failure to Pay (after a certain grace period)3.Restructuring and Modified Restructuring(Restructuring : Company negotiates Changes in the Terms of its Debt with its Creditors as an alternative to formal insolvency

12、proceedings.)4.Obligation Acceleration5.Obligation Default6.Repudiation/Moratorium(Repudiation : Refusal to pay a lawful Debt(Moratorium : A Legally Authorised period to Delay Payment of Money due)7.(pre-2003 : Rating Downgrade)ISDA works closely with Risk Management Assoication (RMA), London Invest

13、ment Banking Association and the International Association of Credit Portfolio Managers.CorporatesSovereigns12Credit Default Swap Basics1.3.2 Definition of “Bankruptcy”A Bankruptcy is deemed to have occurred only if it results in the default of the Reference Entitys Obligation.Controvers

14、y is less likely to erupt over whether Bankruptcy has occurred or not,because a written admission of a Companys inability to pay its Debt must be madein a judicial, regulatory or administrative filing.13Credit Default Swap BasicsWhen a Credit Event is triggered, the Protection Seller either takes 1.

15、 Cash Settlement : pays the Protection Buyer the difference between the Par value and Recovery value of the Bond or2. Physical Settlement : delivery of the Defaulted Bond for the Par value. 1.3.3 What will happen if a Credit Event is triggered ?Example on CDS premium payment and Physical SettlementN

16、ote : From BBA (2003/4), 86% of CDS are physically settled, 11% are cash settled and 3% are fixed amount (digital) 14Credit Default Swap Basics1.3.4 Cash Settled ExampleTimeBond Holderor Debt Owneror Lender or CDS buyer“short risk”(Protection Buyer)Bank or Financial Institutionor Swap Counterpartyor

17、 CDS seller“l(fā)ong risk”( Protection Seller )5Ycashflow of CDS premium (quarterly)Fixed LegPays CDS premium quarterlyTimeContingent LegCash Settlement = (1 Recovery Rate) = (1 R)Mark-to-Market of an Argentine plain vanilla Bond = USD 20Cash SettlementProtection Buyer keeps Bond andreceives 100-20 = US

18、D 80from Protection Seller.cashflow of the Corporate Bond(semi-annually)(1 R) = USD 8015Credit Default Swap Basics1.3.5 Physical Settlement ExampleTime5Ycashflow of CDS premium (quarterly)Fixed LegPays CDS premium quarterlyTimePhysical Settlementcashflow of the Corporate Bond (semi-annually)Market P

19、rice of an Argentine plain vanilla Bond = USD 20Physical SettlementProtection Buyer delivers Reference Security,Protection Seller has to pay USD 100.USD 100USD 100Bond Holderor Debt Owneror Lender or CDS buyer“short risk”(Protection Buyer)Bank or Financial Institutionor Swap Counterpartyor CDS selle

20、r“l(fā)ong risk”(Protection Seller )16Credit Default Swap Basics1.3.6 Why Cash Settlement is less popular ?A possible reason :It is because obtaining the quotes for the distressed Reference Credit oftenturns out to be difficult. 17Credit Default Swap Basics1.4.1 Structure of a CDS contractReference Enti

21、tyReference ObligationCredit EventsObligationsDeliverable ObligationsDetermines the Credit Risk to be transferredDefines the Seniority of the ProtectionDefines Trigger Events for the ContractDetermine the Range of Financial Instrumentson which a Credit Event may be observedDetermine the Range of Sec

22、urities that may bedelivered to the counterparty in the event ofthe Contract being triggered (that is, a Credit Event has occurred)18Credit Default Swap Basics1.4.2 Deliverable ObligationsIn general, the Protection Buyer (on Reference Entity)can deliver the following obligations after a Credit Event

23、 :1.Direct Obligations after a Credit Event (“XYZ Motor 7% matured in 2031”).2.Obligations of a Subsidiary of the Reference Entity (“XYZ Finance”).This is known as “Qualifying Affiliate Guarantees,” and the Reference Entitymust hold 50% or more of the Subsidiarys voting shares.3.Obligations of a Thi

24、rd Party guaranteed by the Reference Entity (“ABC Inc”).This is known as “Qualifying Guarantees,” this option requires the option of“All Guaranteed” to be selected in the Contract. 19Credit Default Swap Basics1.4.3 Deliverable ObligationsIn a CDS contract, 1. Parties can select what kind of Obligati

25、onsPayment, Bond (XYZs Bond)and/or Loan(XYZs Loan) to be included in Deliverable Obligations2.Characteristics :Subordination level,Currency Denomination,Listed/Non-listed etc, of such Obligations.20Credit Default Swap Basics1.5 Main Market Standards for CDS contractsEuropean CorporatesUS CorporatesE

26、merging Markets(Latin America, Eastern Europe)Credit EventsBankruptcyFailure to payModified modified restructuringBankruptcyFailure to payModified restructuringFailure to payRepudiation/moratoriumObligation accelerationRestructuringObligationCategoryBorrowed MoneyBorrowed MoneyBondObligationCharacte

27、risticsNoneNoneNot domestic currencyNot domestic lawNot domestic issuanceNot subordinatedPhysicalSettlement Period30 Business DaysSection 8.6 of the ISDA 2003 definitionscapped at 30 Business DaysSection 8.6 of theISDA 2003 DefinitionsDeliverableObligationBond or LoanBond or LoanBondDeliverableOblig

28、ationCharacteristicsStandard specifiedCurrenciesNot subordinatedAssignable loanConsent required loanTransferableNot contingentNot bearerMax. Maturity : 30 yearsStandard specifiedCurrenciesNot subordinatedAssignable loanConsent required loanTransferableNot contingentNot bearerMax. Maturity : 30 years

29、Standard specified CurrenciesNot domestic lawNot domestic issuanceNot subordinatedNot contingentNot bearerTransferable21Credit Default Swap Basics1.6.1 CDS Physical Settlement TimelineUnder the 2003 definitions, the Protection Buyer (on Reference Entity) is required to send the Notice of Physical Se

30、ttlement (NoPS), indicating exactly what obligation is going to be delivered.Note that in a physical delivery, the Protection Buyer can choose, within certain limits, what obligation is going to be delivered.This allows the Protection Buyer to deliver an Obligation that is “cheapest to deliver.”22Cr

31、edit Default Swap Basics1.6.2 CDS Physical Settlement TimelinePhysical Settlement Period is typically 30 businessdays in Europe & Asia, no longer than 30 business days in US.23Credit Default Swap Basics1.7 What are the Factors affecting CDS premium ?1.Maturity of the TradeLonger Maturity Trades

32、command more fees as the Protection Sellertakes on a lot more risk, it is harder to estimate.2.Probability of the Reference Entity going into default (PD term structure)The more probable default is, the higher the fees. A good proxy is Moodys or S&Ps credit ratings. Calculation example : KMVs mo

33、del3.Credit Rating of the Swap Counterparty (Protection Seller)Unlikely to buy Protection on a AAA credit from a BBB bank. If you buy Protection on a BB name, You would pay more with a AAA counterparty than with a A counterparty.4.Relationship “Correlation” between the Reference Entity & Swap Co

34、unterparty *Dealers are most concerned about the Japan-on-Japan risk, especially when both belong tothe same keiretsu. Fuji bank and Nissan both belong to the Fuyo keiretsu.Default protection on Nissan written by Fuji Bank would be considered worthless.5.Expected Recovery Value, RThis is not done un

35、til 2 or 3 months after default to give the market time to estimate the “Recovery Value”* A possible way of identifying this is to check the correlation of their stock prices. 24Credit Default Swap BasicsThe CDS premium is quoted in basis points per annum.The buyer of the CDS makes periodic payments

36、 to the Protection Seller, usually on a quarterly basis, until maturity of the CDS or until a Credit Event occurs.If such trigger happens, the Protection Buyer only needs to pay the accrued fee up tothe day of the Credit Event.1.8 How to calculate the periodic payment for a CDS ?To calculate the per

37、iodic payment :Notional = USD 2 millionCDS premium = 101 bppaQuarterly Installment= Notional amount * Basis Point * ( days / Day Base )= 2 million*(101/10000)*(91/360) = USD 5,106Dates : 20th March, 20th June, 20th September and 20th December. Credit Default Swaps & Asset Swaps 26Credit Default

38、Swap Basics1.9.1 CDS premium vs Asset Swap spreadFixed couponsAsset Swap = Bond + IRS(to hedge Interest Risk with IRS)Fixed coupons 3m Libor + ASW spreadIn normal circumstances, Basis should be quite small.where Basis = CDS premium Asset Swap spread CDS premiumCredit Default Swap (to hedge Credit Ri

39、sk)3m Libor (funding)SwapBankBond Holder(Protection Buyer) Bank ( Protection Seller ) InterBank 27Credit Default Swap Basics1.9.2 What is Asset Swap ?Asset Swap transforms and converts fixed interest rates to floating interest rates, vice versa.If an investor owns a Bond,thenLong an Asset Swap = pay

40、 fixed/receive float Interest Rate SwapIf the investor does not own a Bond,then Asset Swap is a structure priced at par with the help of upfront payment.Long a par Asset Swap Package = Long a Straight Bond + pay fixed/receive float Interest Rate Swap+ or - upfront payment28Credit Default Swap Basics

41、1.10 CDS vs Asset Swap spread (a possible reference)Asset Swap spreadCDS premium29Credit Default Swap Basics1.11.1 How to benefit from Negative BasisFixed couponsAsset SwapFixed coupons 3m Libor + ASW spreadCDS premiumCredit Default SwapSwap Bank Hedge Fund ( Protection Buyer )ProtectionSellerHedge

42、fund benefits from negative basisby taking a long position in Asset Swap & CDS= Asset Swap spread CDS premium30Credit Default Swap Basics1.11.2 Negative Basis = Trading OpportunityExampleBasis = CDS premium in bppa ASW spread in bppa = 88.7 169.9 = -81.2 Customerised spreadsheet : Ralative Value

43、 & BASIS Asian USD Bonds Focus31Credit Default Swap BasicsCDS premium & FRN (floating rate notes)The best alternative, when possible, is to price CDS via simple replication.CDS and Total Return Swaps are usually priced this way.For example, buying protection via a CDS is functionally equival

44、ent to shorting aFRN with the same maturity, issuer, credit rating and seniority in bankruptcy and buying a corresponding AAA FRN.The payoff on this portfolio equals a payment stream equal to the excess of the FRN coupon over the AAA FRN coupon, plus a contingent payment equal to the loss on the FRN

45、 upon default.Payoff for a single period = Coupon(t)FRN_x Coupon(t)FRN_AAA + contingent paymentIn equilibrium, the value of the CDS should equal the value of the replicating portfolio.How to get indicative data on CDS premium ? 33Credit Default Swap Basics2.1 Quotes on CDS : filtered by numbers or A

46、 to Z34Credit Default Swap Basics2.2 News on CDSNews Code CDV for Credit Derivatives News and AAA for Ratings.More Journalists in more countries than anyone else35Credit Default Swap Basics2.3.1 Get Markit data from Reuters CreditViewsStep 1 : Choose job role as Fixed Income Broker or Fixed Income S

47、ales & Trader or equivalentStep 2 : Click on Credit Views36Credit Default Swap Basics2.3.2 Who is Markit ?Markit Group Limited is the leading provider of independent data, portfolio valuations and OTC derivatives trade processing to the Global Financial and Commodities Markets. The company recei

48、ves daily data contributions from 85 dealing firms, and its services are used by almost 1,000 institutions to enhance Trading Operations, reduce Risk and manage Compliance.Markit developed the industry standard RED identifier codes for the CDS market.37Credit Default Swap Basics2.3.3 How to search f

49、or a Name ? Example : FordFORDMarkit RED is the industry standard alpha-numeric identifier for the credit derivative market, covering over 3,000 scrubbed Reference Entity & Obligation Pairs. 38Credit Default Swap Basics2.3.4 Markits End-Of-Day pricing (4 updates per day)All CDX, iTraxx indices a

50、nd their constituents EOD prices will be captured atOfficial close at 7am GMT(Singapore time 1500 hours)Update end of day Tokyo time 4:30 PM(Singapore time 1530 hours)Update end of day London time 4:30 PM(Singapore time 0030 hours#)Update end of day New York time 4:30 PM(Singapore time 0630 hours)Of

51、ficial EOD at 7am GMTUpdates at end.Tokyo, London & New York timesSNRFOR : SeNioR unsecured or FOReign bond.SECDOM : SECured DOMestic bond.39Credit Default Swap Basics2.3.5 : 5Y CDS in USD for Ford Motor 40Credit Default Swap Basics2.3.6 Reuters Instrument Code, RIC for single name CDSF: Entity

52、Code - Ford Motor, F5Y: Tenor- 5 year, 5YUS: Currency- USD, USA: Seniority/Tier- Senior, SNRFOR, AR: Doc clause - Modified Restructuring, MR, R =MG: Contributor- Markit Intraday data, MGNote: Proceed to Appendix for more41Credit Default Swap Basics2.3.7 All Curves : all CDS quotes for Ford Motor42Cr

53、edit Default Swap Basics Difference in Recovery RatesSNRFOR : SeNioR unsecured or FOReign bond Recovery rate from 25 to 40%SECDOM : SECured DOMestic BondRecovery rate from 70 to 75%43Credit Default Swap Basics Difference in CurrencyDenominated in USDThe 5Y CDS being the most liquid, in

54、 general44Credit Default Swap Basics Document Clause5YTermCDSpremiumin USD30Y6M3Y10Y7YCRMMMRXRSNRFOR : SeNioR unsecured or FOReign bond Recovery rate around 40%SECDOM : SECured DOMestic BondRecovery rate = 75%MM=MR=XRCR : Old (full, or with) RestructuringMM : Modified Modified RestructuringMR

55、 : Modified RestructuringXR: No Restructuring45Credit Default Swap Basics2.3.9 Document Clause : What & Why ? What ?Most Trades include “Materiality Clause” or Document Clause calling for significant price movements in the Reference Credit Bond or Stock.The “Materiality” Clause demands that the

56、Market treats the Credit Event as “True”.Why ?This prevents the CDS from triggering unjustifiably if, for example, the Reference Credit omits a payment with one of its Bankers sinceit disputes the Legality of a Contract.Next,the Protection Buyer would want to interpret the scope of Protection as wid

57、ely aspossible.The Protection Seller would want to interpret it narrowly.46Credit Default Swap Basics2.3.10 What is Debt Restructuring ?When a Company is having trouble making payments on its debt, it will often consolidate and adjust the terms of the Debt in a Debt Restructuring. After a Debt Restr

58、ucturing, the payments on debt are more manageable for theCompany and the likelihood of payment to bondholders increases. Debt Restructuring has been the most problematic Credit Event.The main issue is that, unlike Bankruptcy or Failure to Pay, some Debt Restructuringmay not lead to losses for Inves

59、tors.Moreover, even if Investors suffer financial losses, the amount of losses is moredifficult to determine, if Debt Restructuring involves an exchange of Bonds withdifferent coupons and/or Maturities.47Credit Default Swap Basics2.3.11 Solutions for treating Debt Restructuring IssuesAccordingly, th

60、e current ISDA agreements offers 4 options for treating the Issue ofRestructuring :1.Full Restructuring (CR)This allows the Protection Buyer to deliver Bonds of any Maturity after Restructuring of Debt in any form occurs.2.Modified Restructuring (MR)Modified Restructuring has become common practice in North America in last few years, which li