Learning Module 5

Credit Default Swaps

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Agenda
Learning Module 5: Credit Default Swaps
• Describe credit default swaps (CDS), single-name and index CDS, and the
parameters that define a given CDS product.
• Describe credit events and settlement protocols with respect to CDS.
• Explain the principles underlying, and factors that influence, the market’s
pricing of CDS.
• Describe the use of CDS to manage credit exposures and to express views
regarding changes in shape and/or level of the credit curve.
• Describe the use of CDS to take advantage of valuation differences among
separate markets, such as bonds, loans, and equities.

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 Credit Default Swaps (CDS)

Credit default swaps (CDS):

• Are one of four OTC traded credit-derivative instruments (total return
swaps, credit spread options, credit-linked notes and CDS).
• CDS are the most liquid of the four credit derivatives.
• For a CDS the underlying asset is the credit quality of a borrower.
• Majority of CDS are written on debt issued by corporate borrowers (focus
of this chapter). CDS can also be written on the debt of sovereign, state and
local governments.

CDS Functionality
• CDS are like insurance contracts; as it involves exchange of credit risk
between protection buyers (short credit risk) and sellers (long credit risk)
• Protection buyer pays the seller a periodic premium called CDS spread
(agreed at the start of the contract).
• If a credit event occurs, the protection buyer is compensated by protection
seller, and the periodic payments made by the protection buyer terminate.
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 Credit Default Swaps (CDS)

CDS Functionality
• Value of a CDS will rise and fall as opinions change about the borrower’s
likelihood of default and severity of potential default.
• If market perception of the borrower’s credit quality deteriorates BUT there
is no credit event, the protection buyer is compensated if the contract is
unwound/exited.  In this manner, CDS provides protection against default;
as well as changes in market perception of the borrower’s credit quality.
• Face value of the protection is called ‘notional’ or size of the contract.
• In some cases, it is permissible for the CDS notional to exceed the amount of
debt outstanding of the reference entity.
• Protection buyer does not have to be an actual creditor holding exposure
(i.e., owning a loan, bond). It can be simply a party that believes that there
will be a change in the credit quality of the reference entity.
• A CDS does not eliminate credit risk. Two reasons:
1. Definition of a credit event in the CDS contract may not align with the
actual credit event that occurred, such that the magnitude of change in
CDS value change in value of underlying.
2. Protection buyer bears the risk that the protection seller may default.
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 Credit Default Swaps (CDS)

CDS Payoff:
• Protection buyer (short credit risk) benefits when credit quality of the
underlying deteriorates  Similar to payoff on put option.
• Protection seller (long credit risk) benefits when credit quality of the
underlying improves.
• Investors use CDS to: 1) leverage portfolios, 2) access maturity exposures
not available in the cash bond market, 3) access credit risk while limiting
interest rate risk, 4) improve the liquidity of their portfolios given the
illiquidity in the corporate bond market.
• Benefit of CDS market: CDS market has increased transparency and insight
into the actual cost of credit risk.

CDS Mechanics:
• CDS spread is calculated as the return on a security over market reference
rate (MRR) required to protect against credit risk. Typically this should be
the spread paid by the protection buyer to the seller. BUT…
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 Credit Default Swaps (CDS)

CDS Mechanics:
• Market standardization has led to a standard annual coupon on CDS, 1% on
investment grade bonds and 5% on high yield (junk bonds).
• Not all investment grade bonds have the same credit risk, and neither do high
yield bonds share the same risk  Standard rates may be too high or too low.
• The difference in spreads will require an upfront payment (called upfront
premium) paid either by protection buyer or seller.
• If standard CDS spread < actual spread, buyer makes an upfront payment to
seller equal to the present value of difference between two spreads.
• If standard CDS spread > actual spread, seller makes an upfront payment to
buyer
• The upfront payments will not impact the regular premiums the buyer must
pay to the seller during the life of the CDS.

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 Types of CDS

1. Single Name CDS

• CDS written on a specific fixed income security (reference obligation) of a
specific issuer (reference entity).
• Only a small subset of issuers, typically with large outstanding liquid debt,
have single-name CDS.
• Reference obligation covered by a CDS is usually a senior unsecured
obligation. CDS can also cover any debt obligation issued by the borrower
that is ranked equal to (pari passu) or higher than the reference obligation
(senior unsecured) with respect to the priority of claims.
• CDS pays off when:
 Issuer defaults on the CDS reference obligation OR
 If the issuer defaults on other existing bond issue that is ranked higher or
pari passu (similar ranking) as the reference obligation.

• The payoff is determined based on the cheapest-to-deliver (lowest price)

bond, which is a debt instrument that can be purchased and delivered at the
lowest cost but has the same seniority as the reference obligation.
• Single name CDS terminates upon maturity or if a single credit event occurs.
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 Types of CDS

1. Single Name CDS

Example: Assume that a company with several debt issues trading in the
market files for bankruptcy (i.e. credit event takes place). What is the
cheapest to deliver obligation for a senior CDS contract.?
A. A subordinated unsecured bond trading at 20% of par.
B. A five year senior unsecured bond trading at 50% of par.
C. A two year senior unsecured bond trading at 45% of par.

2. Index CDS
• CDS written on multiple (basket of) issues.
• Markit is a company that produces CDS indexes. The CDS index is not itself
a traded instrument.
• Index CDS are created such that it is possible to trade basket of CDS. The
industry has created traded instruments based on the Markit indexes.
• Index CDS allows participants to take protection on a combination of
companies, similar to how investors can by the S&P500 index futures or
ETF that based on a portfolio of equities.
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 Types of CDS

2. Index CDS
• The Markit indexes are classified by region and further classified (or
divided) by credit quality  The two most traded CDS index products are
the North American indexes (CDX) and the European, Asian, and Australian
indexes (iTraxx). All CDS indexes are equally weighted.
• CDX and iTraxx are sub-divided by credit quality with the CDX IG and
iTraxx Main each comprising 125 entities; and CDX HY and iTraxx
Crossover consisting of up to 75 high-yield entities.
• Investment-grade index CDS are typically quoted in terms of spreads,
whereas high-yield index CDS are quoted in terms of prices.
• For both CDX and iTraxx protection for each issuer is equal. Example, a
$100m notional CDX on 100 issues has a notional of $1m per issue.
• If a credit event occurs for one issue from the entire basket, the CDS does
not terminate. The protection buyer will receive payoff for the defaulted
issue; protection for remaining issues will continue with remaining par.
Example: CDX with $100m notional based on 100 issues. Each issue has a
notional of $1m. If 2 issues default, the buyer receives payout and the CDX
continues to offer credit protection to the buyer with notional $98m.
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 Types of CDS

2. Index CDS
• Markit updates the components of each index every six months by creating
new series while retaining the old series.
• The latest-created series is called the on-the-run series, whereas the older
series are called off-the-run series.
• When an investor moves from one series to a new one it is called a roll.
• Purpose of index CDS: 1) to take positions on the credit risk of the sectors
covered by the indexes, and/or 2) to protect bond portfolios that consist of or
are similar to the components of the indexes.
• Caution! contrary to single name CDS where CDS buyer is short credit risk
and the CDS seller is long credit risk. In an index CDS the buyer of a CDX
is long credit exposure and the seller of a CDX is short credit exposure.

• Pricing of index CDS is highly dependent on the default (credit) correlation

among issues in the basket.
Higher correlation, higher the CDS spread and higher the CDS premium.

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 Types of CDS

3. Tranche CDS
• This CDS covers a combination of borrowers but only up to pre-specified
levels of losses.
• This CDS is similar to tranches in asset backed securities (ABS), where each
tranche was covering a certain level of losses.
• Tranche CDS is a small portion of the CDS market and is beyond the scope
of the CFA curriculum.

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 CDS Credit Event

International Swaps and Derivatives Association (ISDA):

• Is the unofficial governing body of the industry.
• Has a 15-member group that constitute the Determinations Committee (DC)
 Responsible for declaring a credit event.

Three credit events commonly defined in CDS agreements include:

1) Bankruptcy: court provides defaulting party protection from creditors whilst
drafting a plan to repay debts.
2) Failure to pay: issuer misses scheduled interest or principal payment but has
not filed for formal bankruptcy.
3) Restructuring: refers to several events (e,g. reduction or deferral of payment,
change in seniority of an obligation, change in currency of payment). To
qualify as a credit event, the restructuring must be either involuntary
(restructuring is forced on the borrower by the creditors) or coercive
(restructuring is forced on the creditors by the borrower). Debt restructuring
is not a credit event in USA, issuers generally restructure under bankruptcy,
which is a credit event. Restructuring is a credit event in other countries
where use of bankruptcy court to reorganize is uncommon.
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 CDS Credit Event

• Succession event arises when there is a change in the corporate structure of

the reference entity, such as a merger, divestiture, spin-off, or similar action
in which the ultimate responsibility of debt becomes unclear. When such a
case arises the DC will step in to resolve the issue.

Credit events for sovereign and municipal bonds:

• For sovereign and municipal government bonds other types of credit event
may be encountered such as:
1. Moratorium: the government legally authorizes a period of delay in
payment of interest or principal on the debt,
2. Repudiation of debt: the governmental authority challenges the validity
of the entire debt obligation.

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 CDS Settlement

• When a credit event occurs, CDS parties have the right (but not the
obligation) to settle their contracts.
• Settlement occurs 30 days after the declaration of the credit event by the DC.
Contracts are settled either:
1) Physically: protection buyer physically delivers the defaulted issue to
protection seller who in turn pays the buyer the issue’s notional amount.
2) Cash: where protection buyer keeps the possession of the defaulted
security and receives monetary settlement from the seller:

Cash Payout payout ratio notional principal

Payout ratio = 1 – recovery rate (%)

• Actual recovery can be a very long process, as a result, following the credit
event, the industry conducts an auction in which banks and dealers submit
bids and offers for the cheapest-to-deliver defaulted debt. The final bids
determine the recovery rate on the bonds and the payout ratio for the CDS.
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 Example

ABC Corp. files for bankruptcy, triggering various CDS contracts. It has two
series of senior bonds outstanding: Bond X trades at 20% of par; Bond Y trades
at 30% of par. Investor 1 owns $5m Bond X and $10m of CDS protection.
Investor 2 owns $10m of Bond Y and $5m of CDS protection.
1) Determine recovery rate for both CDS contracts.

2) Explain which settlement method (cash vs. physical) would be preferred by

investor 1 and investor 2.

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 Pricing of CDS
Three Factors that Influence the Pricing of CDS:
1) Probability of default – is the likelihood the reference entity will default in
any given year.
o CDS typically cover a multi-year time horizon, the P(D) of a firm is not
constant each year. P(D) usually increases overtime.
o Conditional probability of default (or hazard rate) – is the probability of
default given that no default has occurred previously. P(Default | No
default in earlier years). The higher the hazard rate, the higher the price
of the CDS.

Cumulative P D in year 3 1 1 P D 1 P D 1 P D

2) Loss given default – expected amount of loss in the event of default.

Expected loss = Hazard rate x Loss given default
Loss given default = 1 – recovery rate.

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 Pricing of CDS
Three Factors that Influence the Pricing of CDS:
3) The ‘price’ of the CDS is the fixed coupon rate the protection buyer pays as
premiums to the protection seller.
• For a single name CDS, once a credit event occurs, the buyer will no longer
make premium payments to the seller. Thus the expected value of coupon
payments depends on the probability of default (i.e. hazard rate).
• Payments made by CDS buyer to CDS seller are called ‘premium leg’
• At default, payout from CDS seller to CDS buyer is called ‘protection leg’
• If PV(protection leg) ≠ PV (premium leg); at inception of the CDS the
protection buyer (or seller) may have to make an upfront payment.
Upfront premium% buyer s view CDS spread CDS coupon CDS Duration

OR
Upfront premium % buyer s view
CDS coupon CDS Spread
CDS Duration

CDS price per $100 notional $100 upfront premium

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 Uses of CDS and Credit Derivative Strategies
The following transactions or strategies can be employed with CDS:
1) Curve trades
• Credit curve compares the credit spreads for different bonds from the same
entity across various bond maturities.
• The credit curve is usually upward sloping  longer maturity bonds have
higher credit spreads than shorter maturity bonds.
• Curve trade is a long/short trade where the investor buys and sells credit
protection on same reference entity but for bonds with different maturity.
• If investor perceives the credit curve to flatten  Buy short term CDS and
sell long-term CDS
• If investor perceives the credit curve to steepen  Sell short term CDS and
Buy long-term CDS.

2) Basis Trades
• Transactions that aim to exploit difference in credit spreads between bond
markets and CDS markets.

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 Uses of CDS and Credit Derivative Strategies
3) Options
• Payer options: give holders right to buy (pay for) credit protection in future
• Receiver options: give holders the right to sell (receive premium for) credit
protection in the future.

4) Capital structure trades

• For firm’s expecting increased leverage (eg. LBO’s), buy CDS on bonds to
protect from default & buy calls option on stocks to profit if stock price rise.

5) Index Trades
• Value of CDS index should equal to the sum of the index constituents.
• Investor can engage in arbitrage to exploit pricing differences if the credit
spread of index constituents is priced differently than the index CDS spread.
6) Synthetic CDO’s
• Synthetic CDO’s combine high quality fixed income securities with CDS to
mimic or create the credit risk exposure that is inherent in cash CDO’s.
• If synthetic CDO can be created at lower cost than cash CDO  Arbitrage
exists. Buy the synthetic CDO and sell the cash CDO to make riskless profit.
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 Exam Style Questions
Q1: Sidney Melbourne believes that the economy will head into a recession in 6
months, and that the recession could last up to a year and a half. He is looking at
a 2-year and a 5-year credit default swap (CDS) to protect him from the chance
of default on his Big Aluminum Co. Bonds. What trade is Melbourne most
likely to carry out?
A. Buy the 2-year CDS
B. Sell the 2-year CDS
C. Buy the 5-year CDS

Q2: Abraaj Corp’s chief analyst recently reported that Amber Corp’s five year
bond is currently yielding 8% and a comparable CDS contract has a credit
spread of 5.25%. Since MRR (market reference rate) is 2.5% the chief analyst
has recommended executing a basis trade to take advantage of the pricing of the
Amber Corp’s bonds and CDS.
Assuming the basis trade was executed and if convergence occurs in the bond
and CDS markets the trade will capture a profit closest to:
A. 0.25%
B. 1.75%
C. 2.75%
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