Credit Risk Management

Using Swaps
1. Credit Default Swaps (CDS)
11/04/2013 Bushra Naqvi, PhD, FRM 2
Credit Default Swaps
A CDS is the most popular form of protections
against default.

A swap designed to transfer the credit exposure
of fixed income products between parties. A
credit default swap is also referred to as a
credit derivative contract.
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Credit Default Swaps (CDS)

Its an agreement where the purchaser of the swap
makes payments up until the maturity date of a
contract, or until a credit event occurs.
Payments are made to the seller of the swap in
arrears on a quarterly, semi-annually or annual
basis. In return, the seller agrees to pay off a
third party debt if this party defaults on the
loan.
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Credit Default Swaps
The buyer of a credit default swap receives credit
protection, whereas the seller of the swap
guarantees the credit worthiness of the debt
security. In doing so, the risk of default is
transferred from the holder of the fixed income
security to the seller of the swap. A CDS is
considered an insurance against non-payment.

A buyer of a CDS might be speculating on the
possibility that the third party will indeed
default.
It was invented by Blythe Masters from JP Morgan in
1994.
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Mechanism of CDS
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Credit Default Swaps: Terms
Some of the most important terms to remember when dealing with
CDSs are:
Reference Entity
The reference entity is the entity (or company) upon which default
protection is bought or sold. The reference entity may or may not be
involved directly with the specific CDS transaction.

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Credit Default Swaps: Terms
Credit Event
A credit event is defined as either technical default based on a ratio
calculation or actual default if the firm misses a coupon or principal
payment. Credit events will trigger payments to flow across CDS
counterparties.
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Credit Default Swaps: Terms
Reference Obligation
When a CDS is bought or sold on a reference entity, the purchaser of
the CDS has the right to sell a bond issued by the reference entity to
the seller of the CDS. The bond sold is called the reference obligation.
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Credit Default Swaps: Terms
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 of
notional principal is called the CDS spread and is usually expressed in
basis points.
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CDS Settlements
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CDS Example
Suppose
Global Bank owns a bond issued by KKU
Corporation with a par value of $50 million.
Global would like to protect its position against
credit risk and enters into a CDS with Berndt
Financial.
Swap is initiated on July 1, 2006 and terms of the
CDS call for Global Bank to make payment of 80
basis points to Berndt Financial based on the
notional principal of $50 million for a period of 4
years, or until a credit event occurs.
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CDS Example
1. Who is Reference Entity?
2. Who is the buyer of CDS?
3. Who is the seller of CDS?
4. What is the Notional Principal?
5. What is the CDS spread?
6. What is the maturity of CDS?
7. What is the annual payment to be transferred?
8. What are the two credit events possible?
9. How the CDS can be settled between parties if default
does not occur?
10. How the CDS can be settled between parties if default
does occur
11. What are the financial implication for buyer of CDS if
default occurs on October 1, 2008?
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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 a
specific issue or obligor
Ownership
In a CDS, protection buyer does not need to own the
reference asset; does not need to have an insurable
interest (Moral Hazard)
Default Probability
A CDS transaction contains a greater potential for one
party to possess more information regarding default
probabilities than other parties and therefore have a
more 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 value
of the mid-market (i.e., average of bid and ask
prices) CDS spread on the reference entity.
There are four steps in calculating CDS spread:
1. Calculate the PV of the expected payments
2. Calculate the PV of the expected payoff in the event of
default
3. Calculate the PV of the accrual payment (if any) in the
event of default
4. Calculate the CDS spread

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Valuation of a CDS
Example
Vona Incorporated enters into a 4-year CDS with
Moore Insurance to hedge the credit risk of $200
million bond issued by WK Corporation.
The probability of PWK Corp. (the reference entity)
defaulting during a year, conditional on no earlier
default is 3%
Assuming payments are made once a year, at the
end of the year. The risk-free rate is 6% per year
compounded continuously and recovery rate in the
event of default is 30%. Moreover, defaults are also
assumes too be occurring halfway through a year
Find the CDS spread?
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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 of
default (assume default occurs halfway through
a year)
PV of accrual payment (as defaults are
assumed to be occurring halfway through a
year)
Calculate the CDS Spread
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Default and Survival Probabilities of
PWK 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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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 a
predetermined credit event.
The most common is a first-to-default swap,
which makes a payoff when the first reference
entity in he basket defaults. Other basket
CDSs are usually referred to as nth-to-default
CDSs, where the payoff occurs when the nth
default occurs in a portfolio of companies.
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Portfolio CDS
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Portfolio CDS
The most important factor is determining the
spread for a basket CDS is the default
correlation of the reference entities in the
basket.

Lower the correlation among entities, high the
probability of one or more defaults during
specified period but lower the probability of
maximum defaults. Moreover, lower the value
of nth-to-default as compared to first-to-
default.
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Portfolio CDS
Higher the correlation, the probability of
multiple defaults also increases, thus
increasing the value of an nth-to-default CDS.

Perfect correlation indicates either no
defaults or all default situation, which means
no difference in the value of first-to-default
and nth-to-default CDSs.
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2. Credit Linked Notes (CLNs)
Credit Linked Notes
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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
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Securitization: Role of Participants
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Collateralized Debt Obligations
A particular type of ABS is a Collateralized Debt Obligations (CDO). This is an
ABS where the underlying assets are fixed-income securities.
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Cash CDOs Structure

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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 risk
2. 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 by
underwriters 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
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Synthetic CDOs Structure
Comparison
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