Credit Default Swaps

Praveen P. Mishall
MMS 2008-10 Welingkar Institute of Management Development & Research praveen.mishall@gmail.com

Credit Default Swaps

1 8/18/2009

Agenda
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What are Derivatives? What are Credit Derivatives? What are Credit Default Swaps Subprime Crisis and its implications Role of CDS in Subprime Crisis CDS Auction CDS Data Sources Central Counterparty Settlement for CDS Credit Derivatives Market in India CDS and its settlement in India

Credit Default Swaps

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Derivatives

Derivatives Contract Types
– Forward & Future – Options – Swaps

What are Derivatives?
– Derivatives are financial contracts, or financial instruments, whose prices are derived from the price of underlying.

Risks with Derivatives
– – – – Large losses due to leverage Counterparty risk Large notional amounts Complicated nature of Derivatives

Uses of Derivatives
– Hedging – Speculation – Arbitrage

Driving forces for growth
– Volatility in asset prices – Integration of national market with international – Communication facilities – Risk Management Tools
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Types of Derivatives
– OTC Derivatives – Exchange Traded Derivatives

Credit Default Swaps

OTC Derivatives Growth

“Blaming derivatives for financial losses is akin to blaming cars for drunken driving fatalities” Christopher L. Culp
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4 8/18/2009

Credit Derivatives

What are Credit Derivatives?
– Credit derivatives can be defined as arrangements that allow one party (protection buyer or originator) to transfer, for a premium, the defined credit risk, or all the credit risk, computed with reference to a notional value, of a reference asset or assets, which it may or may not own, to one or more other parties (the protection sellers).

Types of Credit Derivatives
– – – – Credit Default Swap Total Return Swap Credit linked notes Credit spread option

Credit Derivatives Risks
– Credit Risk – Market Risk – Legal Risk

Driving forces for growth
– Securitization – Index products – Tranching (slicing in French)
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Credit Default Swaps

Credit Default Swap

What is Credit Default Swap?
– A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.

General Characteristics
– Quarterly CDS premium (spread) payment – Spread inversely related to quality of underlying – Standard range for deals $10-20 million – Standard maturity of 5 yrs – Maturity directly related to quality of underlying – Important Trigger events  Bankruptcy  Failure to pay  Restructuring 6
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Simple CDS contract (Source: Bionic Turtle)
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Growth of CDS Market

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Credit Default Swap

Types of CDS
– Single-name CDS – Multi-name CDS

Speculation in CDS
– Structured Investment Vehicle (SIV) market – Naked CDS – Secondary market for CDS

Settlement Methods
– Physical Settlement – Cash Settlement – Fixed Amount Settlement

How is CDS different from insurance?
– Seller is not regulated entity – No need to own reference entity – No need to maintain reserves for pay-off

Uses of CDS
– Hedging – Speculation

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CDS Pricing
Value of CDS (to the protection buyer) = PV [contingent leg] – PV [fixed (premium) leg]
Where, D(ti) = Discounting Factor, q(ti) = Survival Probability, S = CDS Premium, di = Accrual days as a fraction of a year, {q(ti-1) - q(ti)} = Survival Probability till credit default event, R = Recovery Rate.
Source: CDS Primer by Nomura Fixed Income Research
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End

Subprime Crisis

Reasons for subprime loans
– – – – Lower interest rates Increase in prices of houses Home equity loans Additional profits to FIs

Types of subprime loans
– Interest Only Mortgage – Adjustable Rate Mortgage (ARM)  2/28 ARM – Low Initial Fixed Rate Mortgage

Predatory Borrowing/ Lending
– Lack of information (Options available)

Moral Hazards
– Loan servicer/ Borrowers
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The sequence of events

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Securitization Process

Source: Infosys

Traching Process
– Senior Tranche – Subordinate/Mezzanine Tranche – Equity Tranche

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Predatory Borrowing and Lending Adverse Selection Moral Hazards
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Role of CDS in Subprime Crisis

Source:YieldCurve.com
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CDS Statistics

Source: Infectious Greed
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CDS Market

OTC Market – Disadvantages
– Due diligence for counterparty creditworthiness (additional cost) – Dealer market (dealers acts as market makers) – No valuation by an independent valuation agent, etc.

Credit Derivative Indices – CDX/ iTraxx
– CDX – North American & Emerging Market companies – iTraxx – Rest of the world – Benefits – tradability, liquidity, operational efficiency, transaction cost, transparency

BIS Recommendations
– Delays in documenting & confirming transactions – Expanding use of collateral – Potential use of clearing house

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The Changes in CDS Market
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Central Counterparty Hardwiring the Auction Protocol ISDA Determination Committee

What is Central Counterparty?
– buyer to every seller and the seller to every buyer

Benefits of CCPs
– – – – – Increased liquidity Multilateral netting Mitigating counterparty risk Neutral, transparent valuation Improve operational efficiency
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Credit Default Swaps

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CDS Auction

Rationale behind Auction Process
– – – – – Physical Settlement of CDS contracts CDS outstanding greater than the volume of bonds issued Artificial rise in the price of the bonds Need for transparent, trustworthy price for Cash Settlement Elimination of Basis Risk

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Overview of CDS Auction Process CDS Auction – Stage 1
– – – – 2-way market quotes Physical settlement request Inside Market Midpoint Open Interest

Stage 1 Results published are –
– The inside market midpoint – The size and direction of the open interest – Any Adjustment Amounts

CDS Auction – Stage 2
– matching open interest and creating a final price

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Auction Process: Lehman Brothers
Quotation Size – $5 million Inside Market Midpoint – 9.75 Open Interest – $4.92 billion to sell Adjustment Amount – $12500 Final Settlement Price – 8.625
Note: Prices are expressed relative to a par value of 100

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CDS Data Sources

International Swaps and Derivatives Association
– – – – ISDA Master Agreement Administrating Auction Process ISDA Determination committee Semiannual Reports

The Office of the Comptroller of the Currency
– Quarterly report on bank derivatives activities in US – OCC shared the regulatory information on CDS after its introduction to market

Bank for International Settlement
– BIS semiannual data for singlename, multi-name instruments – CDS by counterparty, sector and rating

The Depository Trust and Clearing Corporation
– Trade Information Warehouse, comprehensive trade database – Weekly information on credit derivative products, transaction types, etc.

British Bankers' Association
– Reports every two years on credit derivatives activities in London/ Europe
Credit Default Swaps

Other data sources –
– Bloomberg, Markit, S&P, Moodys, Fitch Rating, etc.
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Central Counterparty Settlement

TriOptima

– Elimination of USD 30.2 trillion of CDS notional trades (in 2008) – Elimination of USD 5.5 trillion of CDS notional trades (first quarter of 2009)
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Central Counterparty Settlement

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IntercontinentalExchange Trust NYSE Euronext LIFFE & LCH.Clearnet SA CME Group Inc./ Citadel Investment Group Eurex AG.
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Comparison of CCPs
Parties Program Type Presence in Started on ICE Trust/ CCorp CCP US/ Europe 09/03/2009 Currently - North American CDX indices Proposed - American single names in 3Q09 European iTraxx indices in 2Q09 European single names in 3Q09 NYSE Euronext LIFFE/ LCH CCP Europe 22/12/2008 Currently - iTraxx Europe CDS indices in UK Proposed - iTraxx European indices by Dec 2009 US indices by H12010 CME Group/Citadel E-trading & CCP Europe/ US Yet to start Eurex AG CCP Europe Yet to start

Products

Proposed – CDX indices, iTraxx indices, and single name CDS

Proposed – European index and single name CDS

Pricing by

Markit

Markit

Markit

Eurex clearing pricing team, Markit
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Credit Default Swaps

Comparison of CCPs
Parties ICE Trust/ CCorp Integration and coexistence with other elements of CDS processing infrastructur e (like DTCC) NYSE Euronext LIFFE/ LCH Novation within a Eurozone legal framework LCH.Clearnet SA to act as the CCP ISDA documentation compliance DTCC TIW as central registrar CME Group/Citadel Eurex AG Leverage of existing OTC CDS and Eurex Clearing infrastructure No additional technical connectivity required for existing Clearing Members, STP processing with the DTCC Deriv/SERV Trade Information Warehouse Dedicated clearing fund for CDS

Features

Open architecture, enabling market participants to execute or book CDS trades through party-to-party negotiation, IDB brokered, CMDX Request for Quote (RFQ) platform, or other electronic matching venues Migration Utility to migrate existing bilateral OTC contracts to standardized, centrally cleared contracts

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General Global Settlement Procedure

Functional Model
– DTCC TIW for trade capturing, confirmation and settlement – Check various criteria before novation by central counterparty

Trade Lifecycle
– Flags, novation, netting, collateral, etc.

CDS Pricing

– Markit pricing info. – Eurex clearing pricing team
Credit Default Swaps

Risk Management Model
– Margins & Collaterals

End of day processing
– Reports with current positions, margin summary, collateral reports
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Credit Derivatives Market in India

Need for Credit Derivatives
– Eliminate uneven distribution of risk in market – Banks & FIs highly skewed with loan portfolios with no bond portfolio – Mutual funds, Hedge funds, Insurance companies & Pension funds mostly have bond portfolio and no loan portfolio

Benefits of credit derivatives
– Transfer credit risk & free up capital by banks – Retaining existing client relationship – Construct & manage the credit risk portfolio of own choice – Diversification of credit risk

Minimum Conditions
– – – – Direct Explicit Irrevocable Unconditional

Expected Participants
– Banks, Financial Institutions, Insurance companies, Mutual funds

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25 8/18/2009

RBI Draft Guidelines

Participants allowed
– Protection buyers: Commercial Banks, Primary Dealers – Protection seller: Commercial Banks, Primary Dealers

Product Requirements
– Credit Events
     

Product Requirements
– Protection buyer must have a credit risk exposure – Settlement Methods  Physical Settlement  Cash Settlement  Fixed Amount Settlement – ISDA Master Agreement compliance
Credit Default Swaps

Bankruptcy Obligation Acceleration Obligation Default Failure to pay Repudiation/ Moratorium Restructuring

– Minimum Requirements  Direct, Explicit, Irrevocable & unconditional  No recourse to protection buyer for losses  Specified post-credit-event valuation period  Legal enforceability
Continued…
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RBI Draft Guidelines

Product Requirements
– Minimum Requirements Credit events specified at minimum are – - Failure to pay - Bankruptcy, insolvency - Restructuring – Seniority of underlying – Right/Ability to transfer underlying asset/obligation – Grace period < Loan period – Protection buyer has right to inform Protection Seller about the occurrence of credit event

Risk Management
– Sound risk management policies & procedures (due diligence) – Counterparty limits by PBs – Awareness of legal risk – Adequate oversight by Board of Directors and senior management

Procedures
– Measuring, monitoring, reviewing, reporting and managing the risks – Analysis & minimization of risk – Management of market risk in trading books – Management of legal risk – Management of liquidity reserve
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Credit Default Swaps

CDS and its settlement in India
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Feelers sent out to many banks to check the acceptability Possible CDS Settlement –
– OTC Market – Trade Reporting Platform – Once market matures Central Counterparty Settlement

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Role of CCIL Some issues to be addressed are –

– Regulatory approvals for insurance companies & mutual funds to maximize the number of participants – More lights on restructuring as credit event – Clear distinction between insurance contracts and CDS contracts “There is surely a need for such a product (CDS)”
- Ashish Vaidya, Head of interest rate trading, HDFC Bank.
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References
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BIS Quarterly Review – BIS CDS Trading and Clearing Solution – CME Group Credit Default Swap – Wikipedia A simple explanation of the subprime crisis – David Waring (InformedTrade) Derivative (finance) – Wikipedia CDS: changing the contract – HSBC Global Research Draft CDS Guidelines – RBI European OTC Clearing Solution for CDS – Eurex Clearing Options, Futures and Other Derivatives – John C. Hull Credit Default Swap (CDS) Primer – Nomura Fixed Income Research OCC's Quarterly Report on Bank Derivatives Activities – OCC Report of the Working Group on Introduction of Credit Derivatives in India – Department of Banking Operations and Development Subprime Mortgage Crisis – Wikipedia Introduction to Credit Derivatives – Vinod Kothari
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Credit Default Swaps

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Thank You

Credit Default Swaps

30 8/18/2009

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