Credit Swaps

Credit Default Swaps

1
 Generic Credit Default Swap: Definition

In a standard credit default swap (CDS), a

counterparty buys protection against default by a
particular company or economic entity from a
counterparty (seller).

The company or entity is known as the reference

entity and a default by that entity is known as a credit
event.

The buyer of the CDS makes periodic payments or a

premium to the seller until the end of the life of the
CDS or until the credit event occurs.

2
 Generic Credit Default Swap: Definition

Depending on the contract, if the credit event

occurs, the buyer has

The right to sell a particular bond (or loan) issued

by the company for its par value (physical
delivery)

Or

Receive a cash settlement based on the difference

between the defaulted bonds par value and its
market price (recovery value)

3
 Generic Credit Default Swap: Definition

Example:
Suppose two parties enter into a 5-year CDS with a
NP of $200,000,000.

The buyer agrees to pay 95 bp annually for

protection against default by the reference entity.

If the reference entity does not default, the buyer

does not receive a payoff and ends up paying
$1,900,000 each year for 5 years.

If a credit event does occur, the buyer will receive the

default payment and pay a final accrual payment on
the unpaid premium.
4
 Generic Credit Default Swap: Definition

Example:
Note:
If the event occurs half way through the year, then the buyer pays
the seller $950,000.

If the swap contract calls for physical delivery, the buyer will sell
$200 million par value of the defaulted bonds for $200,000,000.

If there is a cash settlement, then an agent will poll dealers to

determine a mid-market value. If the recovery value were $30 per
$100 face value, then the buyer would receive $140,000,000
minus the $950,000 accrued interest payment.

5
 CDS Terms

1. In the standard CDS, payments are usually made in

arrears either on a quarter, semiannual, or annual basis.

2. The par value of the bond or debt is the notional

principal used for determining the payments of the
buyer.

3. In many CDS contracts, a number of bonds or credits

can be delivered in the case of a default.
A company like Motorola, for example, might have 10 bonds
with similar maturities, coupons, and embedded option and
protection features that a buyer of a CDS could select in the
event of a default.

6
 CDS Terms

4. In the event of a default, the payoff from the CDS is equal to the
face value of the bond (or NP) minus the value of the bond just
after the default.

The value of the bond just after the default expressed as a

proportion of the bonds face value is known as the recovery
rate (RR).
CDS Payoff = (1 RR)NP Accrued Payment

If that value on the $200,000,000 CDS were $30 per $100 face
value, then the recovery rate would be 30% and the payoff to
the CDS buyer would be $140,000,000 minus any accrued
payment.

Payoff = (1 .30)$200,000,000) Accrued Payment

Payoff = $140,000,000 Accrued Payment
7
 CDS Terms

5. The payments on a CDS are quoted as an annual

percentage of the NP.

The payment is referred to as the CDS spread.

8
 CDS Terms

6. Swap bankers function as both brokers and dealers

in the CDS market.
As dealers, they will provide bid and ask quotes
on a particular credit entry.

For example, a swap bank might quote a 5-year

CDS on a GE credit at 270 bp bid and 280 bp
offer.
The swap bank will buy protection on GE for 2.7% of
the underlying credits principal per year for 5 years

The swap bank will sell protection on GE for 2.8% of

the principal.

9
 CDS Uses

CDS are used primarily to manage the

credit risk on debt and fixed-income
investment positions.

10
 CDS Uses

Example 1:
Consider a bond fund manager who just purchased a
5-year BBB corporate bond at a price yielding 8%
and wanted to eliminate the credit risk on the bond.

To eliminate default risk, suppose the manager

bought a 5-year CDS on the bond.

If the spread on the CDS were equal to 2% of the

bonds principal, then the purchase of the CDS
would have the effect of making the 8% BBB bond
a risk-free bond yielding approximately 6%.
11
 CDS Uses

Example 1:
That is, if the bond does not default, then the bond fund
manager will receive 6% from owning the bond and the
CDS (8% yield on bond 2% payment on CDS).

If the bond defaults, then the bond manager would

receive 6% from the bond and CDS up to the time of
the default and then would receive the face value on the
bond from the CDS seller, which the manager can
reinvest for the remainder of the 5-year period.

Thus, the CDS allows the manager to reduce or

eliminate the credit risk on the bond.

12
 CDS Uses

Example 2:
Suppose a manager holding a portfolio of 5-year
U.S. Treasury notes yielding 6% expected the
economy to improve and therefore was willing to
assume more credit risk in return for a higher return
by buying BBB corporate bonds yielding 8%.

As an alternative to selling his Treasuries and

buying the corporate bonds, the manager could sell
a CDS.

13
 CDS Uses

Example 2:
If he were to sell a 5-year CDS on the above 5-year
BBB bond to a swap bank for the 2% spread, then the
manager would be adding 2% to the 6% yield on his
Treasuries to obtain an effective yield of 8%.

Thus with the CDS, the manager would be able to

obtain an expected yield equivalent to the BBB bond
yield and would also be assuming the same credit risk
associated with that bond.

14
 CDS Uses

Example 3:
Consider a commercial bank with a large loan to a
corporation.

Prior to the introduction of CDS, the bank would

typically have to hold on to the loan once it was
created.

During this period, its only strategy for minimizing its

loan portfolios exposure to credit risk was to create a
diversified loan portfolio.

15
 CDS Uses

Example 3:
With CDS, such a bank can now buy credit
protection for the loan.

In general, CDSs allow banks and other financial

institutions to more actively manage the credit risk
on their loan portfolio, buying CDSs on some loans
and selling CDSs on other.

Today, commercial banks are largest purchasers of

CDS and insurance companies are the largest sellers.

16
The Equilibrium CDS Spread

17
 The Equilibrium CDS Spread

In equilibrium, the payment or spread on a

CDS should be approximately equal to the
credit spread on the CDSs underlying bond
or credit.

18
 The Equilibrium CDS Spread

Example:
If the only risk on a 5-year BBB corporate bond
yielding 8% were credit risk and the risk-free rate
on 5-year investment were 6%, then the bond would
be trading in the market with a 2% credit spread.

19
 The Equilibrium CDS Spread

Example:
If the spread on 5-year CDS on a BBB quality bond
were 2%, then an investor could obtain a 5-year
risk-free investment yielding 6% by either
Buying a 5-year Treasury
or
Buying the 5-year BBB corporate yielding 8%
and purchasing the CDS on the underlying
credit at a 2% spread

20
 The Equilibrium CDS Spread

Example:
If the spread on a CDS is not equal to the credit
spread on the underlying bond, then an arbitrage
opportunity would exist by taking positions in the
bond, risk-free security, and the CDS.

21
 The Equilibrium CDS Spread

CDS Spread = 1% < Credit Spread = 2%

Suppose a swap bank were offering the above CDS for
1% instead of 2%.

In this case, an investor looking for a 5-year risk-free

investment would find it advantageous to create the
synthetic risk-free investment with the BBB bond and
the CDS.

That is, the investor could earn 1% more than the yield
on the Treasury by creating a synthetic treasury by
1. Buying the 5-year BBB corporate yielding 8%
and
2. Purchasing the CDS on the underlying credit at a 1%
22
 The Equilibrium CDS Spread

CDS Spread = 1% < Credit Spread = 2%

If the swap bank were offering the above CDS for
1% instead of 2%, then an arbitrager could realized
a free lunch equivalent to a 5-year cash flow of 1%
of the par value of bond by
1. Shorting the Treasury at 6% (or borrowing at
6%)
2. Using the proceeds to buy the BBB corporate
3. Buying the CDS

23
 The Equilibrium CDS Spread

CDS Spread = 1% < Credit Spread = 2%

These actions by investors and arbitrageurs,
in turn, would have the impact of pushing
the spread on the CDS towards 2%the
underlying bonds credit spread.

24
 The Equilibrium CDS Spread

CDS Spread = 3% > Credit Spread = 2%

If the swap bank were offering the CDS at a 3%
spread, then an investor looking for a 5-year risk-
free investment would obviously prefer a 6%
Treasury yielding 6% to a synthetic risk-free
investment formed with the 5-year BBB corporate
yielding 8% and a CDS on the credit requiring a
payment of 3%.

25
 The Equilibrium CDS Spread

CDS Spread = 3% > Credit Spread = 2%

If the swap bank were offering the CDS at a 3%
spread, then a more aggressive investor looking to
invest in the higher yielding 5-year BBB bonds,
though, could earn 1% more than the 8% on the BBB
bond by creating a synthetic 5-year BBB bond by
1. Purchasing the 5-year Treasury at 6%
2. Selling the CDS at 3%

26
 The Equilibrium CDS Spread
CDS Spread = 3% > Credit Spread = 2%
If the swap bank were offering the CDS at a 3%
spread, then a bond portfolio manager holding 5-year
BBB bonds yielding 8% could pick up an additional
1% yield with the same credit risk exposure by
1. Selling the BBB bonds
2. Selling the CDS at 3%
3. Using the proceeds from the bond sale to buy
the 5-year Treasuries yielding 6%

27
 The Equilibrium CDS Spread

CDS Spread = 3% > Credit Spread = 2%

If the swap bank were offering the CDS at a 3%
spread, then an arbitrager could realized a free lunch
equivalent to a 5-year cash flow of 1% of the par
value on the bond by
1. Shorting the BBB bond
2. Selling the CDS
3. Using proceeds from bond sale to purchase 5-
year Treasuries

28
 The Equilibrium CDS Spread

CDS Spread = 3% > Credit Spread = 2%

With these positions, the arbitrageur would receive for
each of the next 5 years 6% from her Treasury investment
and 3% from her CDS, but only pay 8% on her short BBB
bond position.

Furthermore, her holdings of Treasury securities would

enable her to cover her obligation on the CDS if there was
a default.

That is, in the event of a default she would be able to pay

the CDS holder from the net proceed from selling her
Treasuries and closing her short BBB bond by buying
back the corporate bonds at their defaulted recovery price.
29
 The Equilibrium CDS Spread

CDS Spread = 3% > Credit Spread = 2%

Collectively, the actions of the investors, bond
portfolio managers, and arbitrageur would have the
effect of pushing the spread on CDS from 3% to
2%.

30
 The Equilibrium CDS Spread

In equilibrium, arbitrageurs and investors should

ensure that the spreads on CDS are approximately
equal to spreads on the underlying bond or credit.

This spread can be defined as the equilibrium

spread and is referred to as the arbitrage-free
spread and the Z-spread.

31
 CDS Spread and the Expected Default Loss

The arbitrage-free spread, Z, on a bond or

CDS can also be thought of as the bond
investors or CDS buyers expected loss
from the principal from default.

32
 CDS Spread and the Expected Default Loss

Consider a portfolio of 5-year BBB bonds trading

at a 2% credit spread.

The 2% premium that investors receive from the

bond portfolio represents their compensation for an
implied expected loss of 2% per year of the
principal from the defaulted bonds.

33
 CDS Spread and the Expected Default Loss

If the spread were 2% and bond investors believed that

the expected loss from default on such bonds would be
only 1% per year of the principal, then the bond
investors would want more BBB bonds, driving the
price up and the yield down until the premium reflected
a 1% spread.

If the spread were 2% and bond investors believed the

default loss on a portfolio of BBB bond would be 3%
per year, then the demand and price for such bonds
would decrease, increasing the yield to reflect a credit
spread of 3%.

34
 CDS Spread and the Expected Default Loss

Thus, in an efficient market, the credit spread on

bonds and the equilibrium spreads on CDS represent
the markets implied expectation of the expected loss
per year from the principal from default.

In the case of a CDS, the equilibrium spread can

therefore be defined as the implied probability of
default of principal on the contract.

35
CDS Valuation

36
 CDS Valuation
The total value of a CDSs payments is equal to
the sum of the present values of the periodic CDS
spread (Z) times the NP over the life of the CDS,
discounted at the risk-free rate (R):
M
Z NP
PV (CDS Payments) t
t 1 (1 R )

37
 CDS Valuation
In terms of the above example, the present value of
the payment on the 5-year CDS with an
equilibrium spread of 2% and a NP of $1 would be
$0.084247:
5
(.02)($1)
PV (CDS Payments) t
$0 .084247
t 1 (1.06)

38
 CDS Valuation
The buyer (seller) of this 5-year CDS would
therefore be willing to make (receive) payments
over five years that have a present value of
$0.084247.

39
 CDS Valuation
Because the spread can also be viewed as an
expected loss of principal, the present value of the
payments is also equal to the expected default
protection the buyer (seller) receives (pays).

The value of the CDS protection, in turn, is equal

to the present value of the expected payout in the
case of default.

40
 CDS Valuation

The present value M

p t NP(1 RR )
of the expected PV (Expected Payout) t
payout in the case t 1 (1 R )
of default:

where: pt = probability of default in period t conditional

on no earlier default.
RR = recovery rate (as a proportion of the face
value) on the bond at the time of default.
NP = notional principal equal to the par value of
the bond.

41
 CDS Valuation
Note that the probability of default, pt, is defined as
a conditional probability of no prior defaults.
Thus the conditional probability of default in
Year 4 is based on the probability that the bond
will survive until Year 4.

In contrast, an unconditional probability is the

likelihood that the bond will default at a given time
as seen from the present.

42
 CDS Valuation
As noted in Chapter 5, conditional default
probabilities are referred to as default intensities.

Over a period of time, these probabilities will

change, increasing or decreasing depending on the
quality of the credit.

43
 CDS Valuation
Instead of defining a CDSs expected payout in terms
periodic probability density, pt, the CDSs expected payout
can alternatively by defined by the average conditional
default probability, p :
M
p NP(1 RR )
PV (Expected Payout)
t 1 (1 R ) t
M
1
PV (Expected Payout) pNP(1 RR )
t 1 (1 R ) t

44
 CDS Valuation

Given the equilibrium spread of .02 in our example

and assuming a recovery rate of 30% if the
underlying bond defaults, the implied probability
density for our illustrative CDS would be .02857.

This implied probability is obtained by solving for

the p that makes the present value of the expected
payout equal to present value of the payments of
$.084247.

45
 CDS Valuation
PV (Expected Payout) PV (Payments)
M
p NP(1 RR ) M Z NP
The implied probability
(1 R )t (1 R )t
t 1 t 1
is obtained by solving Z
for the p that makes p
(1 RR )
the present value of the
expected payout equal .02
p .02857
to present value of the (1 .30)
payments:
M
p NP(1 RR )
PV (Expected Payout) t
t 1 (1 R )
5
(.02857) ($1)(1 .30)
PV (Expected Payout) (1.06) t
t 1
PV (Expected Payout) $0.084247
46
 CDS Valuation
Note that if there were no recovery (RR = 0), then
the implied probability would be equal to the spread
Z, which as noted can be thought of as the
probability of default of principal.

The probability density implied by the market is

referred to as the risk-neutral probability because it
is based on an equilibrium spread that is arbitrage
free.

47
Alternative CDS Valuation

48
 Alternative CDS
Valuation Approach

Suppose in the illustrative example, the

estimated default intensity, sometimes referred
to as the real world probability, on the 5-year
BBB bond were .02 and not the implied
probability of .02857.

49
 Alternative CDS
Valuation Approach
In this case, the present value of the CDS expected
payout would be $0.058973 instead of $0.084247:
5
(.02) ($1)(1 .30)
PV (Expected Payout) t
$0.058973
t 1 (1.06)

50
 Alternative CDS
Valuation Approach
Given the spread on the CDS is at 2% and the
present value of the payments are $0.084247,
buyers of the CDS would have to pay more on the
CDS than the value they receive on the expected
payoff ($0.058973).

If the real world probability density of .02 is

accurate, then buyers of the CDS would eventually
push the CDS spread down until it is equal to the
value of the protection.

51
 Alternative CDS
Valuation Approach

For the payment on the CDS to match the expected

protection, the spread would have to equal .014.

This implied spread is found by solving for the Z

that equates the present value of the payments to the
present value of the expected payout given the real
world probability of .02 and the estimated recovery
rate of RR = .30.

52
 Alternative CDS
Valuation Approach
PV (Payments) PV (Expected Payout)
M M
Z NP p NP(1 RR )
The spread, Z, that (1 R )t (1 R )t
t 1 t 1
equates the present
value of the payments to Z p (1 RR )
the present value of the Z (.02)(1 .30) .014
expected payout given
the real world
probability is .014. M
Z NP
PV (Payments) t
t 1 (1 R )
5
(.014) ($1)
PV (Payments) t
t 1 (1 . 06)
PV (Payments) $0.058973
53
 Comparison of Valuation Approach

We now have two alternative methods for

pricing a CDS.

54
 Comparison of Valuation Approach

1. We can value the CDS swap given the credit spread

in the market and then determine the present value
of the payments;

In terms of our example, we would use the market

spread of 2% and value the swap at $0.084247 with
the implied probability density (or risk-neutral
probability) being .02857.

See Slide 46.

55
 Comparison of Valuation Approach

2. We can value the swap given estimated probabilities

of default and then determine the present value of the
expected payout.

In terms of our example, we would use the estimated

real world probability of .02 and value the CDS at
$0.058973 with the implied credit spread being .014.

See Slide 53.

56
 Comparison of Valuation Approach

What valuation method should be

used?

57
 Comparison of Valuation Approach

Some scholars argue for the use of valuing swaps

with risk-neutral probabilities or equivalently
pricing swaps in terms of credit spreads on the
underlying bonds because it reflects an arbitrage-
free price.

Thus, in our example they would price the 5-year

CDS equal to the 2% spread with a total value of
$0.084247.

58
 Comparison of Valuation Approach

If one can estimate real-world probabilities on bonds

and CDS that are more accurate than the probabilities
implied by current credit spread, then eventually the
bond and CDS market will price such claims so that
the credit spread reflects the real world probability.

If this is the case, then in our example one should

price the 5-year CDS at $0.058973 given the estimated
probability density of .02.

The argument for pricing CDS using real world

probabilities depends on the ability of practitioners to
estimated default probabilities.
59
 Estimating Default Rates and Valuing CDS
Based on Estimated Default Intensities

There are several approaches for estimating

conditional probabilities.

The simplest and most direct one is to estimate the

probabilities based on historical default rates.

60
 Estimating Probability Intensities
from Historical Default Rates
The next slide shows three different probabilities for
corporate bonds with quality ratings of Aaa, Baa, B,
and Caa:
1. Cumulative default rates
2. Unconditional probability rates
3. Conditional probability rates (probability
intensities)

61
 Cumulative Default Rates, Probability
Intensities,
and CDS Values and Spreads

M
p t (1 RR )
M
p NP(1 RR ) (1 R ) t
t (1 R ) t Z t 1M
1 62
t 1 (1 R )t
t 1
 Estimating Probability Intensities
from Historical Default Rates

The probabilities shown in the table are the average historical

cumulative default rates from 1970-2006 as complied by
Moodys.

The unconditional probability of a bond defaulting during year

t is equal to the difference in the cumulative probability in year
t minus the cumulative probability of default in year t 1.

Example: The probability of a Caa bond default during year 4

is equal to 7.18% (= 46.9%% 39.72%).

63
 Estimating Probability Intensities
from Historical Default Rates
As previously noted, the conditional probability is the probability of
default in a given year conditional on no prior defaults.

This probability is equal to unconditional probability of default in

time t as a proportion of the bonds probability of survival at the
beginning of the period.

The probability of survival is equal to 100 minus the cumulative

probability.

Example: The probability that a Caa bond will survive until the end
of year three is 39.72% (100 minus its cumulative probability
39.72%), and the probability that the Caa bond will default during
year 4 conditional on no prior defaults is 11.91% (= 7.18%/60.28%).
64
 Valuing CDS Based on Estimated
Historical Default Intensities

Using the conditional probabilities generated from the historical

cumulative default rates, the values and spreads for four CDS
with quality ratings of Aaa, Baa, B, and Caa are shown in Slide
62.

Each swap is assumed to have a maturity of five years, annual

payments, NP of $100, and recovery rate of 30%.

The values are obtained by determining the present values of the

expected payoff, with the discount rate assumed to be 6% and
with the possible defaults assumed to occur at the end each year
(implying there are no accrued payments).

The spreads on the CDS are the spreads that equate the present
value of the payments to the present value of the expected
payoff.
65
 Valuing CDS Based on Estimated
Historical Default Intensities

Example:
The present value of the expected payoff for the CDS with a
B quality rating is 17.78:
M
p t NP(1 RR )
PV(Expected Payoff )
t 1 (1 R ) t
.0524 .06395 .0647125 .0603905 .0608082
PV(Expected Payoff ) ($100)(1 .3)
(1.06) (1.06)
2
(1.06) 3
(1.06) 4
(1.06)5
PV(Expected Payoff ) 17.78

66
 Valuing CDS Based on Estimated
Historical Default Intensities

M
Z NP M
p t NP(1 RR )
Example:
t 1 (1 R )
t

t 1 (1 R ) t
The spread on the B- 5
$100
quality CDS that Z t
$17.78
equates the present t 1 (1.06)
value of its payments to $17.78 $17.78
the expected payoff of Z 5 .0422
$100 $421.2364
$17.78 is .0422: t 1 (1 .06 ) t

67
 Valuing CDS Based on Estimated
Historical Default Intensities

Example:
As shown in Slide 62, the present values of the
expected payoffs on the Caa quality CDS is
$41.43 and its spread is 0.0983.

As expected, the CDS values and spreads are

greater, the greater the default risk.

68
 Estimating Expected Default Rates:
Implied Default Rates

The above default rates are based on historical

frequencies.

Past frequencies are often not the best predictors

of futures probabilities.

If the market is efficient such that the prices of

bonds reflect the markets expectation of future
economic conditions, then the implied
probabilities based on CDSs risk spread would
represent an expected future default probability.

69
 Estimating Expected Default Rates:
Implied Default Rates

We previously calculated the average implied probability by

solving for the probability that equated the present value of
the expected payoff to the present value of the payments
based on the current bonds credit spread.

Using this methodology, one could estimate the implied

conditional probabilities for each year for a given quality
rating using the CDS spread on 1-year to m-year swaps.

This would result in a set of implied default probabilities that

could be used to determine the spread on any swap.

70
 Estimating Expected Default Rates:
Implied Default Rates

The table shows the spreads (Z) and the implied probability
densities given an assume recovery rate of 30% on 5 B-rated CDS
with maturities ranging from 1 to 5 years:

The implied probability densities are equal to Z(1 RR).

71
 Estimating Expected Default Rates:
Implied Default Rates

Given the implied probabilities, the value of a 5-year CDS

based on its expected payoff would be $18.83 and its
spread would be .0447:
M
p t NP(1 RR )
PV(Expected Payoff )
t 1 (1 R ) t
.0571 .0607 .0643 .0679 .0714
PV(Expected Payoff ) ($100)(1 .3) 2
3
4
5
(1 .06 ) (1 .06) (1 . 06) (1 .06 ) (1 .06 )
PV(Expected Payoff ) $18.33

M
Z NP M
p t NP(1 RR )

t 1 (1 R ) t

t 1 (1 R ) t
5
$100
Z t
$18.83
t 1 ( 1 .06 )
$18.83 $18.83
Z 5 .0447
$100 $421.2364

t 1 (1.06)
t
72
 Summary of the Two
Valuation Approaches
1. Pricing CDS in Terms Credit Spreads
Many scholars argue for valuing CDS in terms
credit spreads on the underlying bonds because it
result in an arbitrage-free price.

Pricing CDS in terms of bond credits spreads also

implies that the default probability for determining
the expected payout by the seller is a probability
implied by the credit spread of bonds traded in the
market and not a real-world estimated probability.

73
 Summary of the Two
Valuation Approaches

2. Pricing CDS Based on Estimates of the

Conditional Probability
The alternative to pricing CDS in terms of bond
credit spreads is to determine the spread that will
equate the present value of the payments to the
present value of the expected payout based on
estimates of the conditional probability.

Default probabilities can be estimated using

historical cumulative default rates and implied
default rates.

74
 Summary of the Two
Valuation Approaches

Note:
There are a number of other more advanced
estimating techniques that practitioners can use to
determine default probabilities.

Of particular note is Gaussian Copula Model.

75
 The Value of an
Off-Market CDS Swap

76
 The Value of an Off-Market CDS Swap

Similar to a generic par value interest rate swap,

the swap rate on a new CDS is generally set so
that there is not an initial exchange of money.

Over time and as economic conditions change the

credit spreads on new CDS, the value of an
existing CDS will change.

77
 The Value of an Off-Market CDS Swap

Example:
Suppose one year after a bond fund manager bought
our illustrative 5-year CDS on BBB bond at the 2%
spread, the economy became weaker and credit
spreads on 4-year BBB bonds and new CDS on such
bonds were 50 bp greater at 2.5%.

Assume for this discussion that CDS spreads are

determine by bond credit spreads in the market.

78
 The Value of an Off-Market CDS Swap

Example:
Suppose the bond fund manager sold her 2%
CDS to a swap bank who hedged the CDS by
selling a new 2.5% CDS on the 4-year BBB
bond.

With a buyers position on the assumed 2% CDS

and sellers position on the 2.5% CDS, the swap
bank, in turn, would gain 0.5% of the NP for the
next four years.

79
 The Value of an Off-Market CDS Swap

Example:
Given a discount rate of 6%, the present value of this gain would
be $1.73 per $100 NP. The swap banks would therefore pay the
bond manager a maximum of $1.73 for assuming the swap.

Offsetting Swap Positions

Buyer of 2% CDS Swap Pay 2% of NP Receive Default Protection
Seller of 2.5% CDS Swap Receive 2.5% Pay Default Protection
Receive 0.5%
per year

4
(Current Spread Exisitng Spread)( NP)
SV
t 1 (1 R ) t
4
0.005 ($100)
SV
t 1 (1. 06) t
$1.73

80
 The Value of an Off-Market CDS Swap

With four years left on the current swap, the increase in

credit spread in the market has increased the value of
the buyers position on the CDS swap by $1.73 from
$6.93 to 8.66:
4
(.02)($100)
Exisitng CDS : PV(CDS Payments)
t 1 (1.06) t
$6.93
4
(.025)($100)
Current PV(CDS Payments) t
$8.66
t 1 (1.06)
Change in Value $1.73

81
 The Value of an Off-Market CDS Swap

The increase in value on the buyers position of

the exiting swap reflects the fact that with
poorer economic conditions, the 2% swap
payments now provide greater default protection
(i.e., the present value of the expect payout is
greater).

82
 The Value of an Off-Market CDS Swap

For the initial seller, an increase in credit

spreads causes a decrease in the value on
sellers positions.

83
 The Value of an Off-Market CDS Swap

Example
Suppose that an insurance company was the one
who sold the 5-year CDS on the BBB bond at
the 2% spread to the bond portfolio manager
(via a swap bank) and that one year later the
credit spread on new 4-year CDS on BBB bonds
was again at 2.5%.

84
 The Value of an Off-Market CDS Swap

Example:
If the insurance company were to sell its sellers
position to a swap bank, the swap bank could
hedge the assumed position by taking a buyers
position on a new 4-year, 2.5% CDS on the BBB
bond.

With the offsetting positions, the swap bank

would lose 0.5% of the NP for the next four
years.

85
 The Value of an Off-Market CDS Swap

Example:
Given a discount rate of 6%, the present value of this loss
would be $1.73 per $100 NP. The swap banks would therefore
charge the insurance company at least $1.73 for assuming the
sellers position on the swap:

Offsetting Swap Positions

Seller of 2% CDS Swap Receive 2% of NP Pay Default Protection
Buyer of 2.5% CDS Swap Pay 2.5% Receive Default Protection
Pay 0.5% per year

4
(Current Spread Exisitng Spread)( NP)
SV
t 1 (1 R ) t
4
0.005 ($100)
SV
t 1 (1.06) t
$1.73

86
 The Value of an Off-Market CDS Swap

Example
For the insurance company, the increase in the
credit spread has decreased the value of their
sellers position on the CDS swap by $1.73.

That is, for the increase in credit risk, the seller

should be receiving $8.66 instead of $6.93.

87
 The Value of an Off-Market CDS Swap

Alternatively stated, the poorer economic

conditions reflected in the greater credit spreads
have increased the probability of default on the
BBB bonds and as a result has increased the
present value of the sellers expected payoff.

88
 The Value of an Off-Market CDS Swap
With the credit spread increasing from 2% to 2.5%, the implied
conditional default rate on the bond has increased from .02857 to .
035714, increasing the present value of the sellers expected
payout from $6.9302 to $8.66:
Z .02
Exisitng p .02857
(1 RR ) (1 .30)

Z .025
Current : p .035714
(1 RR ) (1 .30)
M
p NP(1 RR )
PV (Expected Payout)
t 1 (1 R ) t
4
(.02857) ($100)(1 .30)
Exisitng : PV (Expected Payout)
t 1 (1.05) t
$6.93
4
(.035714) ($100)(1 .30)
Current : PV (Expected Payout)
t 1 (1 . 05) t
$8.66
89
 The Value of an Off-Market CDS Swap

Summary:
To summarize, an increase in the credit spread
will increase the value of the buyers position on
an existing CDS and decrease the sellers
position.

Just the opposite occurs if economic conditions

improve and credit spreads decrease.

90
Other Credit Derivatives

91
 Other Credit Derivatives

The market for CDS has grown dramatically over the

last decade. With that growth there has been an
increase in the creation of other credit derivatives.

The most noteworthy of these other credit derivative

are the
1. Binary swap
2. Credit swap basket
3. CDS forward contracts
4. CDS option contracts
5. Contingent swaps
92
 Binary CDS

A binary CDS is identical to the generic CDS

except that the payoff in the case of a default is a
specified dollar amount.

Often the fixed payoff is the principal on the

underlying credit. When this is the case, then the
only difference between the generic and binary
swap is that the generic CDS adjust the payoff by
subtracting the recovery value whereas the binary
CDS does not.

93
 Credit Swap Basket
In a basket credit default swap, there is a group
of reference entities or credits instead of one and
there is usually a specified payoff whenever one
of the reference entities defaults.

Typically, after the relevant entry defaults, the

swap is terminated.

94
 Credit Swap Basket

Basket CDS can vary by the type of agreement

governing the swap:
Add-up basket CDS provides a payout when any
reference credit in the basket defaults

First-to-default CDS provides a payout only when the

first entry defaults

Second-to-default CDS provides a payout when the

second default occurs

Nth-to-default CDS provides a payout when the nth

credit entry defaults.

95
 CDS Forward Contract
A CDS forward contract is a contract to take a
buyers position or a sellers position on a
particular CDS at a specified spread at some
future date.

CDS forward contract provide a tool for locking

in the credit spread on future credit position.

96
 CDS Option Contract
A CDS option is an option to buy or sell a
particular CDS at specified swap rate at a
specified future time.

Example: A one-year option to buy a 5-year CDS

on GE for 300 bp.
At expiration, the holder of this option would exercise
her right to take the buyers position at 300 bp if current
5-year CDSs on GM were greater than 300bp.

In contrast, she would allow the option to expire and

take the current CDS on GE if it is offered at 300 BP or
less.
97
 CAT Bond
Somewhat related to credit risk is the catastrophic
(CAT) risk that insurance companies face in
providing protection against hurricanes,
earthquakes, and other natural disasters.

Insurance companies often hedge CAT risk

through reinsurance.

Note: One CAT hedging product that insurance

companies are increasingly using is the issuance
of CAT bonds.

98
 CAT Bond

CAT bonds pay the buyer a higher-than-normal

interest rate. In return for the additional interest,
CAT bondholders agrees to provide protection
for losses from a specified event up to a
specified amount or when the losses exceed a
specified amount.

99
 CAT Bond

Example:
An insurance company could issue a CAT bond
with a principal of $200 million against a
hurricane cost exceeding $300 million.

The CAT bondholders would then lose some or

all of their principal if the event occurs and the
cost exceeds $300 million.

100