Credit Derivatives

Credit Derivatives

1. What ?

   • Credit derivatives are contracts where the payoff depends on the creditworthiness of one or more companies or countries
   • Banks have been the biggest buyers of credit protection and insurance companies have been the biggest sellers
   • can be categorized as
     • "single-name"
       • The most popular single-name credit derivative is a credit default swap (CDS)
       • The payoff from this instrument depends on the worthiness of one company or country
       • There are two sides to the contract: the buyer and seller of protection
       • There is a payoff from the seller of protection to the buyer of protection if the specified entity (company or country) defaults on its obligations
     • "multi-name"
       • The most popular multi-name credit derivative is a collateralized bebt obligation (CDO)
   • Basis point
   • Recovery rate for a bond
     • is normally defined as the price at which the bonds trades about 30 days after default, as a percent of its face value

2. why?

   • Credit derivatives allow companies to trade credit risks in much the same way that they trade market riks
   • can be used to transfer credit risks to a third party
   • can be used to diversify credit risks
   • A CDS can be used to hedge a position in a corporate bond. Suppose that an investor buys a 5-year corporate ond yielding 7% per yer for its face value and at the same time enters into a 5-yer CDS to buy protection against the issuer of bond defaulting
   • This shows that the excess of an n-year bond yield over the risk-free rate should approximately equal the n-year CDS spread.
     • If it is markedly more than this, an investor can earn more than the risk-free rate by buying the corporate bond and buying protection
     • If it is markedly less than this, an investor can borrow at less than the risk-free rate by shorting the corporate bond and selling CDS protection.

3. How ?

   • Credit default swap (CDS)
     • It is a contract that provides insurance against the risk of a default by particular company.
     • The company is known as the Reference entity and a default by the company is known as a Credit event
     • The buyer of the insurance obtains the right to sell bonds issued by the company for their face value when a credit event occurs and the seller of the insurance agrees to buy the bonds for their face value when a credit event occurs.
     • The total face value of the bonds that can be sold is known as the credit default swap's NOTIONAL PRINCIPAL
     • The buyer of the CDS makes periodic payments to the seller until the expiry of the CDS or until a credit event occurs
     • Payments are usually made quarterly in arrears
     • In the event of default there is a final accrual payment by the buyer
     • Settlement can be specified as delivery of the bonds (more usually) a cash equivalent amount
   • The payoff
     • Usually there are a number of bonds that can be delivered in the event of a default
     • The protection buyer can choose to deliver the bond with the lowest price
     • In practice an auction process is usually used to determine a cash payoff
   • Steps
     • 1. Calculate the probability of default and survival
     • 2. Calculate the PV of survival
     • 3. Calculate the PV of default
     • 4. Calculate the PV of payoff; PV of survival + PV of default = PV of payoff
     • 5. Calculate breakeven CDS spread at breakeven, PV of payoff x breakeven CDS spread = NPV of CDS after default

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