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CDS Presentation With References
CDS Presentation With References
CDS Presentation With References
Pamela Heijmans
Matthew Hays
Adoito Haroon
Credit Default Swaps – Definition
• A credit default swap (CDS) is a kind of
insurance against credit risk
– Privately negotiated bilateral contract
– Reference Obligation, Notional, Premium
(“Spread”), Maturity specified in contract
– Buyer of protection makes periodic payments to
seller of protection
– Generally, seller of protection pays compensation
to buyer if a “credit event” occurs and contract is
terminated.
Credit Default Swaps – Example
Spread, b basis
points per annum
Protection Protection
Buyer Payment on credit event
Seller
The present values of the sum of all payments to The present values of all
the extent they will likely be paid (i.e., taking into expected accrued payments
account survival probability)
(1 R) D(ti )( qi 1 qi )
S
di
D(ti )q(ti )d i D(ti )( qi 1 qi )
2
CDS Pricing – Example
Two portfolios – same maturity, par and nominal values of $100
Portfolios should provide identical returns at time T1
CDS spread = corporate bond spread
T0 – Portfolio A: T0 – Portfolio B:
Long: Risk Free Bond Long: Company’s Corporate Bond
Short: CDS of a Company
(i.e., “Selling Protection”)
T1 – No Default:
Risk free bond’s payoff: $100 Corporate bond’s payoff: $100
No payment made on CDS
T1 – Credit event: Assume a recovery rate of 45%
Risk free bond’s payoff: $100 Corporate bond’s payoff: $45
Payment on CDS: 55% of $100 notional
Negative Basis Trades
• Investor buys a bond and buys protection on the
same entity. If the basis is negative – the credit
default swap spread is less than the bond spread –
the trader can receive a spread without taking on any
default risk. However, the investors takes on
counterparty risk.
• For example, suppose a bank structures a CDO and
takes down a AAA tranche paying a spread of 27bps.
The bank can then buy protection from an insurer
(such as AIG) for 17 bps, pocketing 10 bps.
Growth So Far
CDS Outstanding Notional (billions)
70,000.00
60,000.00
Billions outstanding
50,000.00
40,000.00
30,000.00
20,000.00
10,000.00
-
1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 1H08
Semi-Annual breakdown
Systemic risks
After couple of
months: Buys CDS
protection on Delta
Airlines
JP Morgan
Netting
Buys CDS
protection on Delta
Airlines
After couple of
months: Buys CDS
protection on Delta
Airlines
Effectively
Goldman has
bought CDS JP Morgan
protection from
JPMorgan
What are the risks in this market?
• Network effects
– CDS are bilateral contracts often sold and resold
among parties
– Buyers may not be as financially sound to cover
the obligation in case of a credit event specially
without collateral
– In 2005 NY Fed advised that counterparties tell
their trading partners when they’ve assigned the
contract to others
Network (domino) effects
Buys CDS
Buys CDS
Lehman JP Morgan
Network (domino) effects
Buys CDS
After couple of
JP sells CDS months: Buys CDS
protection
Buys CDS
Lehman JP Morgan
Network (domino) effects
Buys CDS
Post collateral.
Clearinghouse Automatic netting.
Lehman
JP Morgan
Current state of clearinghouse
• As of Nov 12., the Fed wants to be the regulator for clearing
trades.
• Two competing platforms:
– The CME (Chicago Mercantile Exchange):
• Entered into joint venture with Citadel
• They are waiting for regulatory approval to begin clearing CDS
trades.
– The ICE (Intercontinental Exchange) is also competing. It
has bought Clearing Corp. a company which specializes in
clearing trades.
• Has a trade clearing platform (“Concero”) and is owned partly by
some of the major dealers like Goldman Sachs, Deutsche Bank,
Morgan Stanley etc.
Ending thoughts
As we know, there are known knowns; there
are things we know we know. We also know
there are known unknowns; that is to say we
know there are some things we do not know.
But there are also unknown unknowns—the
ones we don’t know we don’t know. (Donald
Rumsfeld, US dept of defense 2002)
References
• http://www.securitization.net/pdf/content/Nomura_CDS_Primer_12May04.pdf
• http://www.securitization.net/pdf/Nomura/SyntheticABS_7Mar06.pdf
• http://www.quantifisolutions.com/History%20of%20Credit%20Derivatives.php
• Fitch Ratings, Special Report: A Brief Review of “The Basis,” January 10, 2008.
• Fitch Ratings, Special Report: The CDS Market and Financial Guarantors – Current Issues, February 27, 2008
• Laing, J. R., Defusing the Credit-Default Swap, in Barron’s, November 17, 2008.
• Morgenson, G., Arcane Market is Next to Face Big Credit Test, in The New York Times, February 17, 2008.
• RECOMMENDED: Federal Reserve Bank of Atlanta, Economic Review, Fourth Quarter 2007:
– Preface – Credit Derivatives: Where’s the Risk
– Credit Derivatives: An Overview
– Credit Derivatives and Risk Management
– Credit Derivatives, Macro Risks, and Systemic Risks
• Clearinghouse News:
– http://www.bloomberg.com/apps/news?pid=20601087&sid=awdIS.zeotuY&refer=home
– http://www.bloomberg.com/apps/news?pid=20601087&sid=apgBhmu_U.Fo&refer=home
• ISDA statistics - http://www.isda.org/statistics/historical.html
• Federal Reserve Board presentation - www.frbsf.org/economics/conferences/0611/Nelson.ppt
• General paper about systemic risk by ECB - http://www.ecb.int/pub/pdf/scpwps/ecbwp035.pdf
• Counterparty Risk Management Policy Group (Policy report from Gerald Corrigan of Goldman Sachs & Douglas Flint of HSBC
to Secretary Paulson & Mario Draghi of the Bank of Italy) - http://www.crmpolicygroup.org/docs/CRMPG-III.pdf
• AIG downfall - http://www.forbes.com/2008/09/28/croesus-aig-credit-biz-cx_rl_0928croesus.html
• http://www.nytimes.com/2008/09/28/business/28melt.html?sq=aig%20cds%20london&st=cse&scp=2&pagewanted=all
• Nouriel Roubini’s website - http://www.rgemonitor.com/economonitor-
monitor/253566/would_lehmans_default_be_a_systemic_cds_event