Credit Default Swap

(CDS)
 Agenda

 Types of CDS contracts

 Key Terms

 Types of CDS deals

 CDS contract legs

 Benefits of CDS

 Settlement type

 Types of CDS contracts

 Preferred CDS

 Loan only CDS

 AB CDS

 Trends in CDS market

Salient Features

Salient Features of a Credit Default Swap Contract

 Bilateral, Over the counter (OTC): A CDS contract is negotiated between

counterparties and hence it is not traded on any exchanges

 One party “insures” another party against risk and loss due to financial
default: In a CDS contract, one counterparty promises to pay to the other party
a pre-determined amount in case of risk or loss suffered by the other
counterparty due to a financial default by a third unrelated counterparty.

 Of a third unrelated entity (Reference Entity): As mentioned above the risk

or loss suffered by one party due to a financial default by a third unrelated
counterparty is insured by the other party. This unrelated counterparty is known
as Reference Entity.

 In exchange for a premium or fee: The party that is insuring the payment for
the risk or loss suffered is undertaking it for a price and this price is called as
premium.

 Buyer purchases credit protection from the seller: The party insuring the
other party is called as seller of protection and the party who takes this
protection from the other party is called as buyer of protection.
CDS Terms

 Protection Buyer:
A company or an individual generally known as a “risk shedder” who protects himself against the loss that he
may incur on his exposure to an individual loan or bond as a result of unforeseen development (credit event)

 Protection Seller:
A company or an individual generally known as a “risk taker” who protects the buyer against the loss that he
may incur on his exposure to an individual loan or bond as a result of unforeseen development (credit event)

 Reference Entity:
A company who has issued some debt in the form of a reference obligation (Bond) or the borrower of loan
from the buyer

 Reference Credit (Reference Obligation):

The bond issued or the loan borrowed by the Reference Entity

 Premium:
Fees paid by the buyer to the seller for protecting him from the risk of default by the reference entity

 Credit Event:
A condition of poor financial standing of the reference entity / credit, typically threatening the company’s
going-concern nature and/or it’s ability to pay back obligations. The types of credit events are Bankruptcy,
Failure to pay, Restructuring, Obligation Acceleration, Obligation Default, and Repudiation/Moratorium.
Credit Event

Premium/Fee
Protection Seller Protection Buyer

Reference Credit
Bond/Loan

t
v en
dit e
c re Signs a CDS Contract

Contingent Payment

Contingent payment:
• Physical Settlement: Seller pays par on delivery of defaulted assets of the
Reference Credit by the Buyer
• Cash Settlement: Seller pays par minus market value of defaulted assets of the
Reference Credit (or a specific one, the Reference Obligation)

Therefore it is very similar to buying an insurance

 Types of Credit derivative Deals

• Single name products: Derivative security which has only one reference credit asset.
 Credit Default Swaps, Credit Linked Notes, etc.

 Multi-name (or correlation) products: Derivative security which has more than one
reference credit asset, covers a portfolio of defaultable assets, such as Basket Default
Swaps, Collateralized Debt Obligations (CDOs), CDO2, etc.

- Multi-name products require more complicated pricing techniques due to the need for
correlation modeling.

Other Essentials of a CDS:

• Settlement: This is the process that is triggered when the credit event occurs or
when the CDS matures. This process involves transfer of dues from either party
to be made to their counterparty.

Settlement can occur in two ways:

1. Physical settlement
2. Cash settlement
 Participant Legs of CDS contract

What is a CDS contract?

 This is the most popular credit derivative instrument (covers 73 % of outstanding

notional of the credit derivatives market).

 Over The Counter (OTC) type contract between the protection Buyer (B) and
protection Seller (S).

 B makes fixed payment(s) (CDS premium or spread) to S at fixed intervals or

lump sum up-front payment (digital default swap or binary swap).

premium leg

 B pays the premiums to S until the credit event or until CDS matures.
 If credit event does not occur until maturity of CDS, S pays nothing to B.
 If credit event occurs before maturity, S guarantees to pay the loss of B.

protection leg

 Default payment can be optional (cash settlement or physical delivery).

 A la carte CDS

A credit default swap (CDS) is a contract that provides insurance against the risk
of a default by a 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 a particular bond issued by the
company for its par value when a credit event occurs. The bond is known as the
reference obligation and the total par value of the bond that can be sold is known
as the swap’s notional principal.

The buyer of the CDS makes periodic payments to the seller until the end of the
life of the CDS or until a credit event occurs. A credit event usually requires a final
accrual payment by the buyer. The swap is then settled by either physical delivery
or in cash.

If the terms of the swap require physical delivery, the swap buyer delivers the
bonds to the seller in exchange for their par value. When there is cash settlement,
the calculation agent polls dealers to determine the mid-market price, Q, of the
reference obligation some specified number of days after the credit event. The
cash settlement is then (100 − Q)% of the notional principal.
 Benefits of CDS

Protection buyer benefits:

1. It frees up regulatory capital, which facilitates additional business. It may provide better capital
relief than an insurance policy or some other unfunded risk participation arrangement.

2. Credit default swaps may make it easier to purchase and match for a desired maturity. Because
users are stripping out credit only, the tool may prove less expensive than alternative risk transfer
solutions while providing a faster payout.
For example, with trade credit insurance policies, there can be a waiting period of between 180 and
360 days that must expire before the buyer can file a claim against the insurer to recover. With a
credit default swap, the buyer can get payout in approximately four to six weeks following the event of
a default.

3. Since there is no transfer of ownership of the underlying asset, the credit default swap tool solution
can be cheaper and more flexible than an assignment.

4. And since it is governed by ISDA standards, it can be clearly documented and easily implemented.

Protection seller benefits:

1. Credit default swaps provide protection sellers with the ability to take a view on both deterioration
and amount of risk, investment returns for the seller are potentially higher compared to more
'traditional' financial improvement in a company's performance.

2. For the same instruments like bonds Sellers can access additional asset classes they may not
otherwise have, and may better match a maturity with investment appetite. For the protection seller,
there is no initial cash outlay and no need to own the asset; and there will be none unless there is an
event of default or if other arrangements have been made for settlement.

3. In addition to being highly beneficial to the protection seller, ISDA's standardized documentation
facilitates the timely closing of transactions.
 Settlement Types

There are two types of settlement when credit default swaps are used: cash and
physical

 Cash

Under a cash settlement, there is no delivery of the reference obligation. A market

auction of the reference obligation takes place after the credit event occurs, the
benefits of which go to the protection buyer. The seller of protection then makes a
cash payment to the buyer for the difference, if any, between the calculation amount
and the recovery value of the reference obligation.

N X [Reference price – (Final price + Accrued interest on reference obligation)]

 Physical

Under a physical settlement, subject to receipt of any required consents, the buyer of
protection delivers title to its claim against the reference entity to the seller of
protection. The provider of protection then has a claim on the reference entity. The
provider of protection then makes a cash payment to the buyer of protection for the
calculation amount (i.e., nominal value of the bonds) less any accrued fee payable.

Back
 Example

An example may help to illustrate how a typical deal is structured.

Suppose that two parties enter into a five-year credit default swap on March 1,
2000. Assume that the notional principal is $100 million and the buyer agrees to
pay 90 basis points annually for protection against default by the reference entity.

If the reference entity does not default (that is, there is no credit event), the
buyer receives no payoff and pays $900,000 on March 1 of each of the years
2001, 2002, 2003, 2004, and 2005. If there is a credit event a substantial payoff
is likely. Suppose that the buyer notifies the seller of a credit event on September
1, 2003 (half way through the fourth year).

If the contract specifies physical settlement, the buyer has the right to sell $100
million par value of the reference obligation for $100 million. If the contract
requires cash settlement, the calculation agent would poll dealers to determine the
mid-market value of the reference obligation a predesignated number of days after
the credit event. If the value of the reference obligation proved to be $35 per
$100 of par value, the cash payoff would be $65 million.

In the case of either physical or cash settlement, the buyer would be required to
pay to the seller the amount of the annual payment accrued between March 1,
2003 and September 1, 2003 (approximately $450,000), but no further payments
would be required.
 Types of CDS contracts
 Binary CDS:
In a Binary credit default swap the payoff in the event of a default is a specific dollar amount.

 Basket CDS:
In a basket credit default swap, a group of reference entities are specified and there is a payoff
when the first of these reference entities defaults.

 Contingent CDS:
In a contingent credit default swap, the payoff requires both a credit event and an additional
trigger. The additional trigger might be a credit event with respect to another reference entity
or a specified movement in some market variable.

 Dynamic CDS:
In a dynamic credit default swap, the notional amount determining the payoff is linked to the
mark-to-market value of a portfolio of swaps.

 Cancelable DS:
This is a combination of a default swap and default swap option. Either the buyer (callable
default swap) or the seller (putable default swap), or both, have the right to terminate the
default swap.

 Leveraged DS:
In leveraged or geared default swap, the payoff is a multiple of the loss amount. The payoff is
usually determined as the payoff of a standard default swap plus a certain percentage of the
notional amount. Of course, these are much costlier swaps in the market.
 Preferred CDS or pCDS

 Preferred CDS is just another type of credit default swap. No new ISDA documents are
required to trade PCDS, as it shares the majority of traits with traditional CDS. There are
just two major differences:

 PCDS includes the deferral of a trust preferred coupon or preferred stock

dividend as a fourth credit event:
A company can defer or suspend payments on preferred level securities while continuing
to pay interest on more senior debt. Accordingly, the deferral feature is included as a
fourth credit event in addition to bankruptcy, failure to pay, or restructuring.

 PCDS references preferred-level securities as an additional deliverable:

While the majority of default swaps reference companies’ senior unsecured debt, the
reference
asset for PCDS is either preferred or trust preferred stock. If a credit event (including
deferral) occurs, the buyer of protection can deliver either a preferred/trust preferred
security or any obligation more senior in the capital structure. Optionally, convertible
securities are deliverable upon cessation of dividend, while mandatory converts are not.

 Premium of pCDS Probability

are calculated in the same
of Default manner as that
x Senior Probability
of a usual of
CDSDeferral Only
contract, x
with
Premium =
a twist of factoring +
the probability of a deferral occurring. 100% - Min (Recovery of all
recovery-preferred recovery
Deliverable Obligations)
 Loan Only CDS or LCDS

 LCDS is a form of credit default swap under which only a syndicated secured
loan can be delivered upon the physical settlement of the swap. Loan only
credit default swap contracts (LCDS), are also known as “syndicated secured
loan CDS.”

 The most obvious difference between Bond and Loan CDS is the reference
obligation and the deliverables. Loan CDS references a specific priority of
secured debt (1st lien, 2nd lien, etc.), and the deliverable instruments
include the reference obligation, anything pari passu or a more senior
obligation.

 In the United States, Loan CDS generally trades without restructuring as a

credit event, which is also the case for Bond CDS in most High Yield credits.
Contracts are triggered on bankruptcy of the reference entity or failure to
pay with respect to borrowed money of the reference entity or obligations
guaranteed by the reference entity.

 Since the 2003 ISDA definitions do not make a distinction between senior
secured and senior unsecured obligations, Loan CDS confirms contain special
language about the security of the deliverable obligations.
 Key Features of LCDS
 Loan CDS are traded with a callable feature that enables the buyer of protection to call
the contract if the reference obligation is refinanced.

 Even if a Loan CDS contract trades without callability, both parties have the right to
terminate the contract when there is no longer debt of the same priority lien
outstanding.

 Bond CDS, however, will tighten when unsecured debt no longer exists, but the contract
still must be unwound and does not terminate.

 Historically, dealers have used a 65% recovery rate to unwind trades, compared with a
40% recovery rate for most Bond CDS trades.

 Although there has not yet been significant difficulties following the default of a
reference obligation for Loan CDS, there were concerns about being able to settle the
contract within the allotted time period based on the ISDA definitions.

 Unlike bonds, transferring ownership of distressed loans can be complicated due to the
extended assignment process. The new confirms should clarify the settlement
procedures.

 Investors going long credit through Loan CDS must take into consideration that they will
not have all of the same privileges as the owner of the asset. For example, CDS
investors do not have voting rights, will not receive amendment fees, and do not benefit
from amortization payments.
Recap of Recent Credit Events
According to Moody's, 32 issuers defaulted globally for a total of $29 billion in bonds in 2005. Of the defaulted
issuers, 29 were domiciled in the U.S. By volume, the largest default in 2005 was one by Charter
Communications ($6.9 billion), followed by Calpine Corporation ($6.7 billion) and Delta ($3.9 billion). In the first
quarter of 2006, a total of three issuers have defaulted for $1.94 billion.

Obviously, not all defaults result in an index auction. Collins & Aikman was the first reference entity subject to
the industry-wide auction process. After the U.S. auto parts supplier filed for bankruptcy on May 17, 2005,
ISDA
published a protocol to amend existing index-related contracts to cash settlement and to determine the cash
settlement price of the defaulted bonds. The main motive was the fear that there would not be enough
deliverable bonds outstanding to settle index transactions. To date, a total of six index auctions have been
held, with various results (see the table below).
 ABS CDS
 This is a CDS embedded into the cash flows arising from a pool of ABS.

 Here all the underlying assets of an ABS generate cash flows for the ABS securities. When
these ABS securities from different sources are grouped together and then some III-tier
rated securities are floated against this pool, then we get an AB-CDS.

 The AB-CDS floated securities are the stripped payment securities, that are floated in a
secondary market, where investors trade these securities as any stock.

 The secondary market for these securities are specially designed for such obligations. This
is a very active region of the market.

 All the AB-CDS obligations are given a unique identity by means of CUSIP (Committee
on Uniform Securities Identification Procedures) number.

 Stripping a security generates Interest-only (I/O) and Principal-only (P/O) payments.

 Bonds roll every month on the 25th and the CDS on these rolls on the 28th of every month.

 Trustees who have the onus of care-taking a particular CDS, then, release the payment
summary for all the CUSIPs every month. These are the payments that are due on those
CUSIPs for the calculation period.
Pay-off Diagrams

CDS Premium
CDS Buyer (B) CDS Seller (S)

Physical Delivery Reference Asset

CDS Buyer CDS Seller

Face value of
reference asset

Cash settlement
1-R
CDS Buyer CDS Seller

R: Recovery Rate
 CDS Index or CDX

 The CDX is an index where many live CDS contracts are listed and traded into through a CDX
contract.

 It’s a standardized contract where the buyer of the CDX, enters the CDS contract with a
counterparty. The CDS index acts as the underlying for this contract, and the performance of this
index determines the spreads and the settlements between the parties.

 The tradable iTraxx indices are used by investors to hedge entire or partial portfolios in one easy
transaction, rather than achieving the same effect with numerous single name CDS transactions.
Positions can easily be rolled forward or closed as required in only one transaction.

 These indices are easy and efficient to trade. Investors can express their bullish or bearish views on
credit as an asset class, while having the low costs associated with static portfolios and the flexibility
to actively manage credit portfolios. The indices enable investors to trade credit risk separately from
interest rate and/or currency risk.

 While investors use CDS indices to trade large positions in credit names without having direct
exposure to the underlying securities, these same instruments permit other participants, such as
speculators and arbitrageurs, to take part in this market. Taking a long position in, say, iTraxx
Europe – the main investment grade index of 125 equally-weighted names – without exposure to a
cash bond position, offers upside potential in case of underlying credit deterioration. Arbitrageurs can
exploit spread differentials between the CDS, equity and cash markets. The result is additional
liquidity provided by hedge funds and arbitrageurs, and an easier/more efficient risk diversification or
market exposure for the buy-side.

 Correlation also exists between CDS spreads and equity prices. Spreads tend to widen when stock
prices fall and vice versa. Not surprisingly then, stock index returns and volatility are significantly
correlated with iTraxx index spreads; spreads increase (decrease) with rising (falling) stock
volatilities, based on observations of three-month historical volatilities.
 CDS Market Trends

 The leveraged loan market is undergoing rapid change. By combining one of the fastest-growing
asset classes of the year with credit derivative technology, market participants are forecasting a
rapid increase in activity.

 Morgan Stanley and Dresdner Kleinwort Wasserstein (DrKW) have been very instrumental in this
rapid expansion of putative CDS markets in Europe.

 Morgan Stanley started the product development last August and by march 2006 there were already
46 names in the list of trading parties.

 Although the CSD market moved reasonably well in the European and UK, it didn’t do as remarkable
in the US markets. Understood reason for this indifference was the lack of common standards for the
participants to follow.

 Lately SEC has discovered a few major problems with the CDS market. In recent years, the CDS
market has experienced exponential growth. It was therefore not particularly surprising when market
participants were confronted with settlement issues requiring their immediate attention. The fact that
the notional value of traded credit derivatives in some cases far exceeds the amount outstanding of
the relevant corporate bonds, caused concern among the investing community, along with fears
about the effects of credit events on this new market. Alarmed by these events, regulators now
scrutinise the CDS market more closely.

 The most urgent problems – the backlog of unsettled trades and cash settlement for some defaulted
names. Implementation of an auction process has managed to avoid bottlenecks and extreme
market distortions.

 In the autumn of 2005, regulators were forced to recognize the risk that had arisen from the lack of
infrastructure in place in the CDS market, and swiftly drew up plans to reduce it. Buyers and sellers
have since made significant efforts to improve their systems, and technology providers have been
rallying to their aid.
 Business Context

Scenario
 Since the CDS market has grown rapidly our clients have several thousand open CDS contracts today,
and on an average trade 50 new trades a day (typical sizes – USD 10MM). The transactions have all been
traded in the past 5-7 years

 This implies that, trading houses should:

a. quickly ramp up their scale of operations
b. invest in larger, more richer IT resources
c. modify trade execution and booking capability in line with market changes

 Since CDS contract definitions and standards have mutated over the years, all these open contracts have
varying types of risks embedded, creating risk basis which means that the risk on paper (i.e. the trade
contract that is signed by the 2 counterparties) and the risk in their systems (i.e. the electronic record
representing the trade) may not match

 Since valuations and quarterly P&L figures are universally based on system records, this mismatch poses a
very severe regulatory risk

 But docs have moved faster than systems, and understanding of risk parameters has changed, so
systems information can be inadequate for risk assessment and sometimes just wrong information may
exist in the systems.
 eClerx Role

Business Need
 To reconcile the doc risk against the system risk and correct mismatches (if found)
i. Issue – discrepancy between client system and contracts
ii. Client Requirement: accurate data capture and system reconciliation
iii. eClerx Solution: Parametric data-entry software tool with dual key* + auditing process.

 To understand additional risk present in contracts due to the free form nature of the contracts
i. Issue – since each contract is unique, the risk profile has potential to vary across trades
ii. Client Requirement: to analyze and identify these trades and escalate the exceptional cases
iii. eClerx Solution: knowledge of risk conditions coupled with accurate data capture to prepare risk
audits

*Two analysts separately capture data fields from the doc and then these deals are sent for auditing to a auditor.
Trading Cycle

Trader trades with Deal Import

another entity and
enters the details of the
trade on a blotter
Deal Allocation

Trader enters the details Deal Capture

onto the client systems

2-3 Weeks elapse Deal Audit

CDS Contract is drafted

using the system details Reconcile
with Client
systems

CDS Contract is sent for

Counterparty approval Generate and
by the client send update to
client

Due to inherent risks in the docs and discrepancies between client system and docs, the client runs at a
risk emerging from wrong bookings and also various other clauses and conditions

This risk is mitigated and escalated to the client by eClerx by undertaking various data analysis and risk
reconciliation processes