CHAPTER 32

CREDIT DEFAULT SWAPS

CHAPTER SUMMARY
In this chapter, we describe the different types of credit default swap (CDSJ), the basics of CDS
valuation for a single-name CDS, and how a CDS can be used to control risk. We begin with the
critical element in a CDS: the definition of a credit event.

CREDIT EVENTS

A credit default swap (CDS) has a payout that is contingent upon a credit event occurring. The
ISDA provides definitions of what credit events are.

The 1999 ISDA Credit Derivatives Definitions (referred to as the 1999 Definitions) provides
a list of eight credit events: (1) bankruptcy, (2) credit event upon merger, (3) cross acceleration,
(4) cross default, (5) downgrade, (6) failure to pay, (7) repudiation/moratorium, and
(8) restructuring. These eight events attempt to capture every type of situation that could cause
the credit quality of the reference entity to deteriorate, or cause the value of the reference
obligation to decline.

Bankruptcy is defined as a variety of acts that are associated with bankruptcy or insolvency
laws. Failure to pay results when a reference entity fails to make one or more contractual
payments when due. When a reference entity breaches a covenant, it has defaulted on its
obligation. When a default occurs, the obligation becomes due and payable prior to the scheduled
due date had the reference entity not defaulted. This is referred to as an obligation acceleration.
A reference entity may disaffirm or challenge the validity of its obligation. This is a credit event
that is covered by repudiation/moratorium.

The most controversial credit event that may be included in a credit default product is
restructuring of an obligation. A restructuring occurs when the terms of the obligation are
altered so as to make the new terms less attractive to the debt holder than the original terms. The
terms that can be changed would typically include, but are not limited to, one or more of the
following: (1) a reduction in the interest rate, (2) a reduction in the principal, (3) a rescheduling
of the principal repayment schedule (e.g., lengthening the maturity of the obligation) or
postponement of an interest payment, or (4) a change in the level of seniority of the obligation in
the reference entitys debt structure.

Credit Events for an Asset-Backed Security

CDS are written on asset-backed securities (ABS) and referred to as ABS CDS. There are unique
aspects of an ABS that required a modification of the ISDA documentation with respect credit
event definitions when the reference entity is an ABS tranche. In June 2005, the ISDA released
what it refers to as its pay-as-you-go (PAUG) template for ABS. The focus was on cash flow
adequacy of the ABS structure rather than the potential for bankruptcy. Accordingly, the ISDA

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PAUG template provided the following three credit events that focus on cash flow adequacy for
ABS transactions:
Failure to pay. The underlying reference obligation fails to make a scheduled interest or
principal payment.
Writedown. The principal component of the underlying reference obligation is written
down and deemed irrecoverable.
Distressed ratings downgrade. The underlying reference obligation is downgraded to
a rating of Caa2 / CCC or lower

SINGLE-NAME CDS

In a single-name CDS, there is only one reference entity or reference obligation. There are
single-name CDSs written on a
corporate debt issuer (bonds or leverage loans)
sovereign issuer
municipal bond issuer
tranche of an asset-backed security
To explain the mechanics of a single-name CDS we will use an illustration for a CDS written on
a corporate bond issuer. The underlying for the CDS is $10 million par value of the XYZ bond
issue, and a notional amount of $10 million.

The swap premium (the payment made by the protection buyer to the protection seller) is 200
basis points. The standard contract for a single-name CDS calls for a quarterly payment of the
swap premium. The day count convention used for CDSs is actual / 360. Consequently, the swap
premium payment for a quarter is

quarterly swap premium payment =

actual number of days in quarter
notional amount swap rate (in decimal) .
360

Given 92 actual days in a quarter and the swap premium of 200 basis points (0.02), the quarterly
swap premium payment made by the protection buyer would be

92
quarterly swap premium payment = $10,000,000 0.02 = $51,111.11.
360

If a credit event occurs, two things happen. First, there are no further payments of the swap
premium by the protection buyer to the protection seller. Second, a termination value is
determined for the swap.

With physical settlement the protection buyer delivers a specified amount of the face value of
bonds of the reference entity to the protection seller. The protection seller pays the protection
buyer the face value of the bonds. Because unlike in our hypothetical illustration for XYZ
Corporation where only one issue of the reference entity was assumed to be outstanding, in the
real world all reference entities have many issues outstanding and therefore there will be

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a number of alternative issues of the reference entity that the protection buyer can deliver to the
protection seller. These issues are known as deliverable obligations.

An alternative to the standard CDS contract which specifies physical settlement is a fixed
recovery CDS. The type of CDS eliminates the uncertainty on the recovery rate by fixing at the
time of the trade a specific recovery value. With a fixed recovery CDS, if a credit event is
triggered by the reference entity, the protection seller makes a cash settlement that is equal to
100 minus the specified fixed recovery rate.

Approximating the Value of a Single-Name CDS

Lets look at the general principles for pricing or valuing single-name CDS on a corporate bond
issuer. We begin with a set of simplifying assumptions. There are eight assumptions needed to
value a single-name CDS with a maturity of T years for a reference entity. Given these
assumptions, we want to know how the CDS premium, denoted by S, of a single-name CDS with
a maturity of T for some reference entity is determined. Consider the following strategy:
Buy the floating-rate debt obligation with maturity T issued by the reference entity.
Fund the purchase of the floating-rate debt obligation by borrowing for the life of that debt
obligation (which is also the term of the CDS), T, in the repo market.
To hedge the credit risk associated with the floating-rate debt obligation, purchase
protection by buying a CDS with a maturity of T on the reference entity.
This strategy is equivalent to a default-free investment.

Lets look at the payoff for the two possible outcomes: no credit event occurs or a credit event
occurs. If no credit event occurs, then the floating-rate debt obligation matures. Over the life of
the debt obligation, the interest earned is equal to LIBOR + F each period. The cost of borrowing
(i.e., the repo rate) for each period is LIBOR + B. Hence, LIBOR + F is received from ownership
of the asset and LIBOR + B is paid out to borrow funds. The net cash flow is therefore what is
earned: F B. That is, under our simplifying assumptions, the strategy will have a payoff of F
B in the no credit event scenario.

Consider next what would happen if there is a credit event. Assuming physical delivery of the
floating-rate debt obligation, the floating-rate debt obligation is delivered to the credit protection
seller (i.e., the seller of the single-name CDS). Because we assume the credit event occurs right
after the floating-rate debt obligations coupon payment is made, there are no further coupon
payments and no accrued CDS payment. The proceeds obtained from the CDS protection seller
are used to repay the amount borrowed to purchase the floating-rate debt obligation. Hence, the
repo loan has been repaid. As a result, we have the same payoff for this strategy as in the
scenario where there is no credit event: F B.

Asset Swap

When an investor owns an asset and converts its cash flow characteristics, the investor is said to
have created an asset swap. Lets now illustrate a basic asset swap. Suppose that an investor
purchases $10 million par value of a 7.85%, 5-year bond of a BBB rated corporation at par value.

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The coupon payments are semiannual. At the same time, the investor enters into a 5-year
interest-rate swap with a dealer where the investor is the fixed-rate payer and the payments are
made semiannually. Suppose that the swap rate is 7.00% and the investor receives 6-month
LIBOR.

Lets look at the cash flow for the investor every six months for the next five years:
Received from bond: 7.85%
Payment to dealer on swap: 7.00%
+ Payment from dealer on swap: 6-month LIBOR
Net received by investor: 0.85% + 6-month LIBOR

Thus, regardless of how interest rates change, if the issuer does not default, the investor earns 85
basis points over 6-month LIBOR. Effectively, the investor has converted a fixed-rate BBB
5-year bond into a 5-year floating-rate bond with a spread over 6-month LIBOR. Thus, the
investor has created a synthetic floating-rate bond. The purpose of an asset swap is to do
precisely that: create a synthetic credit-risky floating-rate security.

An asset swap typically combines the sale of a credit-risky bond owned to a counterparty at par
and with no interest accrued, with an interest-rate swap. This type of asset swap structure or
package is referred to as a par asset swap. The coupon on the bond in the par asset swap is paid
in return for LIBOR, plus a spread if necessary. This spread is the asset swap spread and is the
price of the asset swap.

To illustrate this asset swap structure, suppose that in our previous illustration the swap rate
prevailing in the market is 7.30% rather than 7.00%. The investor owns the bonds and sells them
to a dealer at par with no accrued interest. The asset swap agreement between the dealer and the
investor is as follows:
The term is five years.
The investor agrees to pay the dealer semiannually 7.30%.
The dealer agrees to pay the investor every six months 6-month LIBOR plus an asset swap
spread of 30 basis points.

Lets look at the cash flow for the investor every six months for the next five years for this asset
swap structure:
Received from bond: 7.85%
Payment to dealer on swap: 7.30%
+ Payment from dealer on swap: 6-month LIBOR + 30 basis points
Net received by investor: 0.85% + 6-month LIBOR

In our first illustration of an asset swap, the investor is creating a synthetic floater without
a dealer. The investor owns the bonds. The only involvement of the dealer is as a counterparty to
the interest-rate swap. In the second structure, the dealer is the counterparty to the asset swap
structure and the dealer owns the underlying credit-risky bonds. If there is a default, the dealer
returns the bonds to the investor.

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CDS Implied Default Probabilities

In the early days of the CDS market, the following nave relationship was used to back out
default probabilities from the observed CDS spread:

Observed CDS spread in bps / 10,000

= (1 Assumed recovery rate) (Assumed default probability)

Note that in this formula, we use default probability. Given an assumed recovery rate, then an
implied default probability can be obtained by solving the above equation for the default
probability:

Observed CDSspread in bps / 10,000

Implied default probability =
1 Assumed recovery rate

Market players will employ an industry standard fixed recovery rate depending on the underlying
to obtain the implied default probability.

INDEX CDS

An index CDS is a CDS written on a standardized basket of reference entities and include CDS
written on
Corporate debt issuers
Sovereign government issuers
Municipal debt issuers
Tranches of asset-backed securities
Tranches of commercial mortgage-backed securities

The mechanics of an index CDS are slightly different from that of a single-name CDS. As with
a single-name CDS, a swap premium is paid. However, if a credit event occurs, once the accrued
payment to the credit event date is paid, the swap premium payment ceases in the case of
a single-name CDS. In contrast, for an index CDS, the swap payment continues to be made by
the protection buyer.

Index CDS Written on Corporate, Sovereign, and Municipal Debt Issuers

The two most actively traded CDX on corporate bonds for reference entities in North America
are the North America Investment Grade Index (denoted by CDX.NA.IG) and the North
America High Yield Index (denoted by CDX.NA.HY).

In addition to index CDS on corporate bond issuers, there is an index CDS on leveraged loans
(denoted LCDX). What differentiates the LCDX from the corporate bond CDX such as the
CDX.HY is that the LCDX references a collection of loans (i.e., any / all outstanding senior
secured bank debt of the reference issuer).

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There are index CDS written on sovereign governments in regions throughout the world. There
is an index CDS written on 50 municipal entities (denoted by MCDX) ranging from general
obligation debt to revenue bonds from municipal authorities.

Index CDS Written on Tranches of ABS

The index CDS written on ABS transactions are called ABX.HE. The index includes 20 home
equity loan deals from the top 20 issuers at the time. The mechanics of an ABX.HE differ from
that of the other index CDS beyond that of defining of a credit event. The other index CDS we
have described exchange payments quarterly. In the case of the ABX.HE, the protection buyer
makes the swap payment monthly based on the notional amount. The notional amount will
decline over time due to the amortization of the tranches.

Index CDS Written on Tranches of Commercial Mortgage-Backed Securities

There are index CDS written on deals of commercial mortgage-backed securities (CMBS). This
index CDS, denoted by CMBX, consists of deals from 25 CMBS transactions. As with the
ABX.HE, there are sub-indices based on tranche ratings. The PAUG template is used as with the
ABX.HE.

ECONOMIC INTERPRETATION OF A CDS AND INDEX CDS

To appreciate the potential application of a CDS and index CDS to control a portfolios credit risk
that will be discussed in the next section, lets look at the economic interpretation of these derivative
products from the perspective of the credit protection seller and the credit protection buyer.

Credit Protection Seller

Consider first the credit protection seller in a single-name CDS. What is the equivalent position
of the credit protection seller in the cash market? For illustration purposes, we will assume that
the reference obligation is bond ABC. If an investor buys bond ABC, then the investor will have
the following cash flow:
Cash outlay equal to bond ABCs price, P0.
Semiannual cash inflows equal to one half of bond ABCs annual coupon rate
The semiannual coupon payments will be received as long as bond ABC does not default.

If the investor sells bond ABC at time T, then there will be a cash inflow equal to bond ABCs
sale price, PT. Suppose that at time T an adverse event occurred causing bond ABCs price to fall
below the purchase price paid by the investor (i.e., PT < P0). The investor then realizes a loss
equal to the PT P0.

Lets look at the cash flow for the credit protection seller where the reference obligation is bond
ABC. This party to the CDS receives a quarterly payment equal to the CDS spread. That is, there
is a cash inflow equal to the quarterly swap payment. However, the swap payments are only
made if bond ABC does not trigger a credit event.

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Lets now suppose that a credit event occurs. The protection seller must make a payment to the
protection buyer. This payment represents a cash outlay or loss for the protection seller. But
consider that there is a loss that occurs for the investor who buys bond ABC if an adverse event
occurs. Once again, this cash flow attribute is similar for both the protection seller and an
investor in a bond.

Consequently, the protection seller has an economic position that is analogous to an investor in
a cash bond (i.e., an investor who owns a bond). This makes sense because both the protection
seller and the investor long a cash bond are buyers of the bond issuers credit risk.

Credit Protection Buyer

It should be no surprise that if the protection seller in a CDS has a position analogous to a long
position in the cash bond that the protection buyer in a CDS has a position analogous to a short
position in a cash bond. Lets see why once again using a single-name CDS where the reference
obligation is bond ABC.

If an investor shorts bond ABC, then the investor will have the following cash flow:
Cash inflow equal to bond ABCs price, P0.
Semiannual cash outflows equal to one half of bond ABCs annual coupon rate

The semiannual coupon payments will be made by the investor because the short is responsible
for reimbursing the party that it borrowed the bond from an amount equal to the coupon
payment. This payment occurs as long as bond ABC does not default.

If the investor buys bond ABC at time T to cover the short position, then there will be a cash
outflow equal to bond ABCs sale price, PT. Suppose that at time T an adverse event occurred
causing bond ABCs price to fall below the price the investor sold the bond short (i.e., PT < P0).
The investor then realizes a gain equal to the P0 PT.

Lets look at the cash flow for the credit protection buyer where the reference obligation is bond
ABC. This party to the CDS makes a quarterly payment equal to the CDS spread. However, the
swap payments are only made if bond ABC does not trigger a credit event. Thus, as with an
investor who shorted bond ABC, there are periodic cash outflows as long as there is no adverse
credit event that stops the payments (default in the case of shorting the cash bond and credit
event in the case of a CDS). This cash flow characteristic of the protection buyers position is
similar to that of a short seller of a cash bond.

Lets now suppose that a credit event occurs. The protection buyer no longer must make any
payment to the protection buyer. Consequently, the protection buyer has an economic position
that is analogous to a short position in a cash bond.

USING CDS FOR CONTROLLING CREDIT RISK

Consider a single-name credit CDS written on a corporate reference entity. The liquidity of the
CDS market compared to the corporate bond market makes it more efficient to obtain exposure

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to a reference entity by taking a position in the CDS market rather than in the cash market. For a
portfolio manager seeking a leveraged position in a corporate bond, this can be done with
a CDS because the economic position of a protection seller is equivalent to a leveraged position
in a corporate bond.

A portfolio manager can shed the exposure to a particular corporate issuer held in a portfolio by
buying protection via a single-name CDS. A reasonable question is why a portfolio manager may
want to do using a CDS rather than merely selling the bond in the cash market. One reason for
less liquid corporate bond names is that conditions in the cash market may be such that it is
difficult for the portfolio manager to sell the current holding of a corporate bond of an issuer for
which the manager has a credit concern.

What is important to note is that although CDS do offer leveraging opportunities for a portfolio
manager who is permitted to do so, no leveraging need occur if the funds that would have been
used to purchase the reference entities are placed in cash rather than used to purchase other
reference entities.

KEY POINTS

Interest-rate derivatives can be used to control interest-rate risk with respect to changes in the
level of interest rates. Credit derivatives can be used to control the credit risk of a security.
By far, the most dominant type of credit derivative is the credit default swap wherein the
protection buyer makes a payment of the swap premium to the protection seller; however, the
protection buyer receives a payment from the protection seller only if a credit event occurs.
The payments for a CDS depend on the triggering of a credit event. The International Swaps
and Derivatives Association documentation for a trade define potential credit events. The
most controversial credit event is restructuring.
There are special credit event definitions for CDS written on tranches of asset-backed
securities (the pay-as-you go definitions).
The is only one reference entity or reference obligation in a single-name CDS, and these
contracts are written on a corporate debt issuer (bonds or leverage loans), sovereign issuer,
tranche of an asset-backed security, and municipal bond issuer.
The value of a single-name CDS can be approximated by the difference between the asset
swap spread (from the par asset swap market) and the spread over LIBOR in the repo market.
An asset swap structured by a dealer firm involves an investor selling a fixed-rate credit risky
bond to the dealer firm and receiving floating-rate payments.
A CDS valuation model can be used to obtain the implied default probability for a reference
entity. However, the probability calculated depends on the validity of the model and the
estimated inputs.
A CDS written on a standardized basket of reference entities is called an index CDS; this type
of CDS is written on corporate debt issuers, sovereign government issuers, municipal debt
issuers, tranches of asset-backed securities, and tranches of commercial mortgage-backed
securities.

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 Unlike a single-name CDS where the contract terminates upon the triggering of a credit event,
for an index CDS, the swap payments continue if a credit event for one of the reference
entities is triggered. However, the swap payments are reduced because of the lower notional
amount resulting from the removal from the index of the reference entity for which a credit
event was triggered.
The economic interpretation of the credit protection seller is that it is analogous to a leveraged
position in the reference entity (in the case of a single-name CDS) or the standardized basket
of reference entities (in the case of an index CDS). For the credit protection buyer, the
position is analogous to a short position in the reference entity or reference entities.
Single-name CDS and be used to alter the credit risk exposure of reference entity. Typically
liquidity is greater in the CDS market than in the cash market and it is easier to short in the
CDS market. An index CDS can be used to adjust the credit exposure of a portfolio:
increasing credit exposure by being the credit protection seller and decreasing credit exposure
by being the credit protection buyer.

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 ANSWERS TO QUESTIONS FOR CHAPTER 32
(Questions are in bold print followed by answers.)

1. How does the role of a credit derivative differ from that of an interest-rate swap in terms
of controlling risk?

Recall that derivatives can be used to control risk (hedging being a special case of risk control
where risk is eliminated) and provide a more transactionally efficient vehicle for doing so. Thus,
a credit derivative controls for a credit risk in a manner that an interest-rate swap cannot. More
details are given below.

A credit derivative is a securitized derivative whose value is derived from the credit risk on an
underlying bond, loan or any other financial asset. In this way, the credit risk is on an entity other
than the counterparties to the transaction itself. This entity is known as the reference entity and
may be a corporate, a sovereign or any other form of legal entity which has incurred debt. Credit
derivatives are bilateral contracts between a buyer and seller under which the seller sells
protection against the credit risk of the reference entity.

An interest rate swap is a derivative involving an agreement between two parties (known as
counterparties) where one stream of future interest payments is exchanged for another based on
a specified principal amount. A company will typically use interest rate swaps to limit or manage
exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it
would have been able to get without the swap. Interest rate swaps expose users to interest rate
risk and credit risk. A typical swap consists of two legs, one fixed, the other floating. Some think
that the risky component is the floating leg, because the underlying interest rate floats and so is
unknown. However, the risky component is in fact the fixed leg because the value of the floating
leg changes very little during the life of a swap. On the other hand the fixed leg of a swap is
equivalent to a coupon bond and fluctuations of the swap rate may have major effects on the
value of the future fixed payments.

To hedge the credit risk associated with the floating-rate debt obligation, one can purchase
protection by buying a credit derivative swap with a maturity of T on the reference entity. Credit
risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the
money, then that party faces credit risk of possible default by another party. Risks involving
credit derivatives are a concern among regulators of financial markets. One challenge in
regulating these and other derivatives is that the people who know most about them typically
have a vested incentive in encouraging their growth and lack of regulation.

2. Why is a portfolio manager concerned with more than default risk when assessing
a portfolios credit exposure?

Credit risk includes three types of risk: (i) the risk that the issuer will default (default risk),
(ii) the risk that the credit spread will increase (credit spread risk), and (iii) the risk that an issue
will be downgraded (downgrade risk). Thus, when assessing a portfolios credit exposure, more
than just default risk needs to be considered.

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3. Answer the below questions.

(a) What is meant by a reference entity?

The ISDA documentation will identify the reference entity and the reference obligation. The
reference entity is the issuer of the debt instrument and hence also referred to as the reference
issuer. It could be a corporation or a sovereign government. For example, a reference entity
could be Sunset Chevrolet Credit Company.

(b) What is meant by a reference obligation?

The reference obligation, also referred to as the reference asset, is the particular debt issue for
which the credit protection is being sought. For example, if the reference entity is Sunset
Chevrolet Credit Company, then the reference obligation would be a specific Sunset Chevrolet
Credit Company bond issue.

4. What authoritative source is used for defining a credit event?

The International Swap and Derivatives Association (ISDA) provide definitions of what credit
events are. The 1999 ISDA Credit Derivatives Definitions (referred to as the 1999 Definitions)
provides a list of eight credit events: bankruptcy, credit event upon merger, cross acceleration,
cross default, downgrade, failure to pay, repudiation/moratorium, and restructuring. These eight
events attempt to capture every type of situation that could cause the credit quality of the
reference entity to deteriorate, or cause the value of the reference obligation to decline.

In January 2003, the ISDA published its revised credit events definitions in the 2003 ISDA
Credit Derivative Definitions (referred to as the 2003 Definitions). The revised definitions
reflected amendments to several of the definitions for credit events set forth in the 1999
Definitions. Specifically, there were amendments for bankruptcy, repudiation, and restructuring.
The major change was to restructuring, whereby the ISDA allows parties to a given trade to
select from among the following four definitions: (i) no restructuring; (ii) full or old
restructuring, which is based on the 1993 Definitions; (iii) modified restructuring, which is
based on the Supplement Definition; and (iv) modified modified restructuring. The last choice
is new and was included to address issues that arose in the European market.

5. Why is restructuring the most controversial credit event?

The most controversial credit event that may be included in a credit default swap is restructuring
of an obligation. A restructuring occurs when the terms of the obligation are altered so as to
make the new terms less attractive to the debt holder than the original terms. The terms that can
be changed would typically include, but are not limited to, one or more of the following:
(i) a reduction in the interest rate, (ii) a reduction in the principal, (iii) a rescheduling of the
principal repayment schedule (e.g., lengthening the maturity of the obligation) or postponement
of an interest payment, or (iv) a change in the level of seniority of the obligation in the reference
entitys debt structure.

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The reason why restructuring is controversial is that a protection buyer profits from the inclusion
of a restructuring as a credit event and feels that eliminating restructuring as a credit event will
erode its credit protection. The protection seller, in contrast, would prefer not to include
restructuring because even routine modifications of obligations that occur in lending
arrangements would trigger a payout to the protection buyer. Moreover, if the reference
obligation is a loan and the protection buyer is the lender, there is a dual benefit for the
protection buyer to restructure a loan. First, the protection buyer receives a payment from the
protection seller. Second, the accommodating restructuring fosters a link between the lender
(who is the protection buyer) and its customer (the corporate entity that is the obligor of the
reference obligation).

6. Why does a credit default swap have an option-type payoff?

A credit default swap has an option-type payoff because the occurrence of a contingent event
triggers the buyer to exercise their right to enhance their value. More details are given below.

Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary
purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default
swaps operate much like a standby letter of credit or insurance policy. In a credit default swap,
the protection buyer pays a fee to the protection seller in return for the right to receive a payment
conditional upon the occurrence of a credit event by the reference obligation or the reference
entity. If a credit event occurs, then the protection seller must make a payment. Because an
option by definition involves a right and not an obligation to do something conditional upon an
event occurring, the credit default swap involves an option-type payoff. The payoff is made
when the credit event occurs in which case the protection buyer settles with the protection seller
and receives the designated payment.

Credit default swaps can be settled in cash or physically. Physical delivery means that if a credit
event as defined by the documentation occurs, the protection buyer delivers the reference
obligation to the protection seller in exchange for cash payment. Because physical delivery does
not rely upon obtaining market prices for the reference obligation in determining the amount of
the payment in a single-name CDS, this method of delivery is more efficient.

Finally, the credit default swap can be documented much like a credit put option where the
amount to be paid by the protection seller is an established strike price less the current market
value of the reference obligation.

7. Comment on the following statement:

Restructuring is included in credit default swaps and therefore the reduction in a
reference obligations interest rate will result in the triggering of a payout. This
exposes the protection seller to substantial risk.

Reduction in a reference obligations interest rate is one term of the contract that can cause
a restructuring. This exposes the protection seller to risk because restructuring tends to favor the
protection buyer. More details are given below.

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The most controversial credit event that may be included in a credit default swap is restructuring
of an obligation. A restructuring occurs when the terms of the obligation are altered so as to
make the new terms less attractive to the debt holder than the original terms. The terms that can
be changed would typically include, but are not limited to, one or more of the following:
(i) a reduction in the interest rate, (ii) a reduction in the principal, (ii) a rescheduling of the
principal repayment schedule (e.g., lengthening the maturity of the obligation) or postponement
of an interest payment, or (iv) a change in the level of seniority of the obligation in the reference
entitys debt structure.

The reason why restructuring is so controversial is a protection buyer benefits from the inclusion
of a restructuring as a credit event and feels that eliminating restructuring as a credit event will
erode its credit protection. The protection seller, in contrast, would prefer not to include
restructuring because even routine modifications of obligations that occur in lending
arrangements would trigger a payout to the protection buyer. Moreover, if the reference
obligation is a loan and the protection buyer is the lender, there is a dual benefit for the
protection buyer to restructure a loan. The first benefit is that the protection buyer receives a
payment from the protection seller. Second, the accommodating restructuring fosters a
relationship between the lender (who is the protection buyer) and its customer (the corporate
entity that is the obligor of the reference obligation).

Because of this problem, the Restructuring Supplement to the 1999 ISDA Credit Derivatives
Definitions (the Supplement Definition) issued in April 2001 provided a modified definition for
restructuring. There is a provision for the limitation on reference obligations in connection with
restructuring of loans made by the protection buyer to the borrower that is the obligor of the
reference obligation. This provision requires the following in order to qualify for a restructuring:
(i) there must be four or more holders of the reference obligation and (ii) there must be consent
to the restructuring of the reference obligation by a supermajority (66 2/3%). In addition, the
supplement limits the maturity of reference obligations that are physically deliverable when
restructuring results in a payout triggered by the protection buyer.

8. All other factors constant, for a given reference obligation and a given scheduled term,
explain whether a credit default swap using full or old restructuring or modified
restructuring would be more expensive.

A credit default swap using the old restructuring should be more expensive to the protection
seller to the extent that it allows for a wider range of acceptable credit events through a more
liberal interpretation that has fewer constraints as to what qualifies for a credit event. However,
to the extent a modified restructuring reduces the costs associated with a credit event, then the
expenses can be reduced. More details are supplied below.

Because of costly squabbles over restructuring, the Restructuring Supplement to the 1999 ISDA
Credit Derivatives Definitions (the Supplement Definition) issued in April 2001 provided
a modified definition for restructuring. There is a provision for the limitation on reference
obligations in connection with restructuring of loans made by the protection buyer to the
borrower that is the obligor of the reference obligation.

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As the credit derivatives market developed, market participants learned a great deal about how to
better define credit events, particularly with the record level of high yield corporate bond default
rates in 2002 and the sovereign defaults, particularly the experience with the 2001-2002 Argentina
debt crisis. In January 2003, the ISDA published its revised credit events definitions in the 2003
ISDA Credit Derivative Definitions (referred to as the 2003 Definitions). The revised definitions
reflected amendments to several of the definitions for credit events set forth in the 1999
Definitions. Specifically, there were amendments for bankruptcy, repudiation, and restructuring.

The major change was to restructuring, whereby the ISDA allows parties to a given trade to select
from among the following four definitions: (i) no restructuring; (ii) full or old restructuring,
which is based on the 1993 Definitions; (ii) modified restructuring, which is based on the
Supplement Definition; and (iv) modified modified restructuring. The last choice is new and was
included to address issues that arose in the European market.

9. The focus in an asset-backed securities CDS is on the cash-paying ability of the collateral
and not on bankruptcy. Why?

CDS are written on asset-backed securities (ABS) and referred to as ABS CDS. As explained in
Chapters 13, 14, and 15, ABS includes a wide range of asset types. Recall that the convention in
the marketplace prior to 2007 was to classify those residential mortgage-backed securities where
the collateral was a pool of subprime mortgage loans as part of the ABS market and not the MBS
market. Consequently, much of the CDS written on ABS involved subprime mortgage pools.

There are unique aspects of an ABS that required a modification of the ISDA documentation
with respect credit event definitions when the reference entity is an ABS tranche. In June 2005,
the ISDA released what it refers to as its pay-as-you-go (PAUG) template for ABS. The focus
was on cash flow adequacy of the ABS structure rather than the potential for bankruptcy. (Recall
from Chapter 15 that the issuer of an ABS is not a corporation but a bankruptcy remote trust.)
Accordingly, the ISDA PAUG template provided the following three credit events that focus on
cash flow adequacy for ABS transactions:
1) Failure to pay. The underlying reference obligation fails to make a scheduled interest or
principal payment.
2) Writedown. The principal component of the underlying reference obligation is written
down and deemed irrecoverable.
3) Distressed ratings downgrade. The underlying reference obligation is downgraded to
a rating of Caa2/CCC or lower

As can be seen, unlike a CDS where the reference entity is a corporation where a credit event is
intended to capture an event of default, the PAUG template seeks to capture any non-default
events that impact the cash flow of the specific reference ABS tranche.

10. Answer the below questions.

(a) For a single-name credit default swap, what is the difference between physical settlement
and cash settlement?

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For a single-name credit default swap (CDS), physical delivery for a credit event means that the
protection buyer delivers a reference obligation to the protection seller in exchange for a cash
payment. For a single-name CDS, physical delivery does not rely on getting market prices for the
reference obligation in determining the amount of cash payment.

For a single-name CDS, cash settlement is not preferred method of settlement. However, if
settled with cash, the termination value is equal to the difference between the nominal amount of
the reference obligation for which a credit event has occurred and its market value at the time of
the credit event. The termination value is then the amount of the payment made by the protection
seller to the protection buyer. No bonds are delivered by the protection buyer to the protection
seller. More details are given below.

The interdealer market has evolved to where single-name CDSs for corporate and sovereign
reference entities are standardized. Although trades between dealers have been standardized,
there are occasional trades in the interdealer market where there is a customized agreement.
Because physical delivery does not rely upon obtaining market prices for the reference obligation
in determining the amount of the payment in a single-name CDS, the method of physical
delivery is more efficient.

The payment by the credit protection seller if a credit event occurs may be a predetermined fixed
amount or it may be determined by the decline in value of the reference obligation. The standard
single-name CDS when the reference entity is a corporate bond or a sovereign bond is fixed
based on a notional amount. When the cash payment is based on the amount of asset value
deterioration, this amount is typically determined by a poll of several dealers. If no credit event
has occurred by the maturity of the swap, both sides terminate the swap agreement and no further
obligations are incurred. The methods used to determine the amount of the payment obligated of
the protection seller under the swap agreement can vary greatly.

To illustrate the mechanics of a single-name CDS, assume that the reference entity or reference
name is XYX Corporation and the underlying is $10 million par value of XYZ bonds. The $10
million is the notional amount of the contract. The swap premiumthe payment made by the
protection buyer to the protection selleris 200 basis points.

The standard contract for a single-name CDS calls for a quarterly payment of the swap premium.
The quarterly payment is determined using one of the day count conventions in the bond market.
The day count convention used for credit default swaps is actual/360, the same convention as
used in the interest-rate swap market. A day convention of actual/360 means that to determine
the payment in a quarter, the actual number of days in the quarter is used and 360 days are
assumed for the year.

Thus, the swap premium payment for a quarter is:

quarterly swap premium payment =

actual number of days in quarter
notional amount swap rate (in decimal) .
360

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For example, assume a hypothetical credit default swap where the notional amount is $10 million
and there are 92 actual days in a quarter. Because the swap premium is 200 basis points (0.02),
the quarterly swap premium payment made by the protection buyer is:

92
quarterly swap premium payment = $10,000,000 0.02 = $51,111.11
360

In the absence of a credit event, the protection buyer will make a quarterly swap premium
payment over the life of the swap. If a credit event occurs, two things happen. First, there are no
further payments of the swap premium by the protection buyer to the protection seller. Second,
a termination value is determined for the swap. The procedure for computing the termination
value depends on the settlement terms provided for by the swap. This will be either physical
settlement or cash settlement.

(b) In physical settlement, why is there a cheapest-to-deliver issue?

There is a cheapest-to-deliver issue because (by convention or design) protection sellers have
been granted an embedded option allowing them to deliver that issue which is the least expensive
or at least the most convenient. More details are given below.

The market practice for settlement for single-name CDSs is physical settlement as opposed to
cash settlement. With physical settlement the protection buyer delivers a specified amount of the
face value of bonds of the reference entity to the protection seller. The protection seller pays the
protection buyer the face value of the bonds. Because all reference entities that are the subject of
credit default swaps have many issues outstanding, there will be a number of alternative issues of
the reference entity that the protection buyer can deliver to the protection seller. These issues are
known as deliverable obligations.

The swap documentation will set forth the characteristics necessary for an issue to qualify as
a deliverable obligation. Recall that for Treasury bond and note futures contracts the short has
the choice of which Treasury issue to deliver that the exchange specifies as acceptable for
delivery. The short will select the cheapest-to-deliver issue, and the choice granted to the short is
effectively an embedded option. The same is true for physical settlement for a single-name CDS.
From the list of deliverable obligations, the protection buyer will select for delivery to the
protection seller the cheapest-to-deliver issue.

11. For a CDS with the following terms, indicate the quarterly premium payment by filling
in the below exhibit.

Swap Notional Days in Quarterly

Premium Amount Quarter Premium Payment
(a) 600 bps $15,000,000 90
(b) 450 bps $ 8,000,000 91
(c) 720 bps $15,000,000 92

In the absence of a credit event, the protection buyer will make a quarterly swap premium
payment given by the below formula:

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 quarterly swap premium payment =
actual number of days in quarter
notional amount swap rate (in decimal) .
360

For swap premium (a) of 600 bps, we insert the given value into our quarterly swap premium
payment formula and get:
90
quarterly swap premium payment = $15,000,000 0.060 = $225,000.00.
360

For swap premium (b) of 450 bps, we insert the given value into our quarterly swap premium
payment formula and get:
91
quarterly swap premium payment = $8,000,000 0.045 = $91,000.00.
360

For swap premium (c) of 720 bps, we insert the given value into our quarterly swap premium
payment formula and get:
92
quarterly swap premium payment = $15,000,000 0.072 = $276,000.00.
360

Below we fill in the missing values in the above exhibit. We have:

Swap Notional Days in Quarterly

Premium Amount Quarter Premium Payment
(a) 600 bps $15,000,000 90 $225,000.00
(b) 450 bps $ 8,000,000 91 $ 91,000.00
(c) 720 bps $15,000,000 92 $276,000.00

12. In the ISDAs pay-as-you go template, why might there be payments by the credit
protection buyer to the credit protection seller beyond that of the swap premium?

Under the ISDAs pay-as-you go template, a trigger event can occur. If so, this causes the credit
protection buyer to make additional payments to the credit protection beyond that of the swap
premium. More details are given below.

The mechanics of an ABX.HE differ from that of the other index CDS described above beyond
that of defining of a credit event. The other index CDS we have described exchange payments
quarterly. In the case of the ABX.HE, the protection buyer makes the swap payment monthly
based on the notional amount. The notional amount will decline over time due to the
amortization of the tranches. The protection buyer receives payments from the protection seller
in the case of a credit event, which as explained earlier results from an interest shortfall, principal
shortfall, or writedowns. However, unlike the other index CDS, under the pay-as-you-go
(PAUG) template a trigger event such as a writedown and interest shortfall may be reversed in
a subsequent period. That is, the protection buyer would have to reimburse the protection seller
in such instances.

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13. How do the cash flows for a CDS swap differ from that of a single-name CDS?

The cash flows for a CDS swap differ from that of a single-name CDS in that the cash flows
cease for the latter when a credit event occurs. More details are provided below.

In a CDS swap, the credit risk of a standardized basket of reference entities is transferred
between the protection buyer and protection seller. As of year-end 2005, the only standardized
indexes are those compiled and managed by Dow Jones. For the corporate bond indexes, there
are separate indexes for investment grade and high-grade names. The most actively traded
contract as of year-end 2005 is the one based on the North American Investment Grade Index
(denoted by DJ.CDX.NA.IG).

The mechanics of an index CDS are slightly different from that of a single-name CDS. As with a
single-name CDS, a swap premium is paid. However, if a credit event occurs, the swap premium
payment ceases in the case of a single-name CDS. In contrast, for an index CDS, the swap
payment continues to be made by the protection buyer. However, the amount of the quarterly
swap premium payment is reduced. This is because the notional amount is reduced as result of a
credit event for a reference entity.

For example, suppose that a portfolio manager is the protection buyer for a DJ.CDX.NA.IG and
the notional amount is $200 million. Using the formula below for computing the quarterly swap
premium payment, the payment before a credit event occurs would be

actual number of days in quarter

$200,000,000 swap rate (in decimal) .
360

After a credit event occurs for one reference entity, the notional amount declines from
$200 million to $199,840,000. The reduction is equal to 99.2% of the $200 million because each
reference entity for the DJ.CDX.NA.IG is 0.8%. Thus, the revised quarterly swap premium
payment until the maturity date or until another credit event occurs for one of the other 124
reference entities is

actual number of days in quarter

$199,840,000 swap rate (in decimal) .
360

As of this writing (2005), the settlement term for an index CDS is physical settlement. However, the
market is considering moving to cash settlement. The reason is because of the cost of delivering an
odd lot of the bonds of the reference entity in the case of a credit event. For example, in our
hypothetical credit default swap index if there is a credit event, the protection buyer would have to
deliver to the protection seller bonds of the reference entity with a face value of $160,000. Neither
the protection buyer nor the protection seller would like to deal with such a small position.

14. How does one approximate the CDS spread for a single-name CDS on a corporate entity?

For a single-name CDS on a corporate entity, one approximate the credit default swap spread by
using the asset swap market for par asset swaps where a proxy for the spread over LIBOR (F)

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can be obtained. The first approximation for a single-name CDS is the difference between the
asset swap spread (from the par asset swap market) and the spread over LIBOR in the repo
market.

15. Answer the below questions.

(a) What is an asset swap?

An asset swap is created by an investor when the investor owns an asset and converts its cash
flow characteristics. An asset swap is an interest rate swap or cross currency swap used to
convert the cash flows from an underlying security (a bond or floating rate note), from fixed
coupon to floating coupon, floating coupon to fixed coupon, or from one currency to another.
The underlying security and swap may be transacted together (as a package) with the same
counterparty or separately with different counterparts. The asset swap may be transacted at the
time of the security purchase or added to a bond or floating rate note already owned by the
investor. A fixed rate bond plus an asset swap converting the bond to floating rate is known as
a synthetic floating rate note. The security plus asset swap can be sold as a package, or
separately. If the issuer of the bond defaults on the issue, the investor must continue to make
payments to the counterparty of the interest-rate swap (i.e., the swap dealer) and is therefore still
exposed to the credit risk of the issuer.

(b) In pricing a single-name CDS, what information does the par asset swap market contain?

There are eight assumptions needed to value a single-name CDS with a maturity of T years for a
reference entity. Assumption 1 states that there exists a floating-rate security issued by the
reference entity that has a maturity of T that is trading at par value and offers a coupon rate of
LIBOR plus a spread denoted by F. (That is, the coupon reset formula for this security is LIBOR +
F.) In practice, we know that Assumption 1 may not hold. That is, for corporate issuers that are
reference entities for a single-name CDS, there is not likely to be a floating-rate security trading at
par. For this reason, market participants look to the asset swap market. Thus, in pricing a single-
name CDS, the par asset swap market contains information that would be provided by a floating-
rate security trading at par (if that security existed).

16. The following is an excerpt from MCDX Municipal CDS index on the rise, Credit Default
Swap Market Reporting, July 1, 2010 (http://blog.creditlime.com/2010/07/01/municipal-cds-index-rising/)
The 5-year MCDX increased from 115 bps to 209 bps during the period from April 20 to
June 11, 2010 and had nearly doubled 11 days later when it closed at 226.5 bps on June
22. Between September 28, 2009 and April 20, 2010, the index had only increased from 90
bps to 115 bps.
The reason for the rise has been obvious, if not evident in CDS market prices, for quite
a while now. Ballooning municipal deficits and lower revenues are creating fiscal
problems for many states across America. California and Massachusetts have both
announced probes (though mostly inconclusive to date) into municipal CDS trading while
Illinois has seen its credit default swaps achieve the status as riskiest state in America.

(a) What is meant by a 5-year MCDX?

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A 5-year MCDX is a credit default swap (CDS) index of 50 municipal credits ranging from
general obligation debt to revenue bonds from municipal authorities (excluding tobacco and
healthcare bond issues). By buying (or selling) the index, you are in effect buying (or selling)
equal portions of 50 different protection contracts. If one of the credits within the MCDX
defaults, the buyer of protection delivers a qualified obligation of the defaulted credit to the seller
of protection. In return the seller of protection pays 100% of the face value. The par amount of
the bond delivered is equal to 1/50th of the original notional amount. Suppose the current 5-year
MCDX spread is 100bps. This means that in order to buy $10 million in default protection
against the 50 names in the MCDX, investors make the equivalent of $100,000 in annual
payments, assuming a new contract were created today. A weak economy generally, and
declining property tax collections specifically, could result in unusual pressure on municipal
credits.

(b) What is the link between the ballooning municipal deficits and lower revenues and
the increase in CDS spreads?

With ballooning municipal deficits and lower revenues, the default probability increases. Thus,
the link between the ballooning municipal deficits and lower revenues and the increase in CDS
spreads reflect the markets view on the default probability associated with the reference entity
and the amount that will be recovered should a default occur. More details are given below.

In the early days of the CDS market, the following nave relationship was used to back out
default probabilities from the observed CDS spread:
Observed CDS spread in bps / 10,000
= (1 Assumed recovery rate) (Assumed default probability)
Note that in this formula, we use default probability. What this means when using a CDS is not
necessarily a bankruptcy but, more broadly, it is the probability of a realizing a credit event.

Given an assumed recovery rate, then an implied default probability can be obtained by solving
the above equation for the default probability:
Observed CDSspread in bps / 10,000
Implied default probability =
1 Assumed recovery rate
So, for example, if the observed 5-year CDS spread for a corporation is 500 basis points and the
assumed recovery rate is 40%, then the implied default probability is 8.33% shown as follows:

Implied default probability = 500 / 10,000 = 0.0833 = 8.33%

1 0.40
Notice that the higher the recovery rate assumed, the higher the implied default probability for
a given CDS spread. So, for example, if a 60% recovery rate is assumed, the implied default
probability is 12.5%.

Market players will employ an industry standard fixed recovery rate depending on the underlying
to obtain the implied default probability. For example, the market practice is to assume a higher

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recovery rate for loans compared to corporate bonds and higher recovery rates for municipal
bonds than for corporate debt.

As the CDS market has matured, it has become widely recognized that the formula given above for
the implied default probability is only a very rough approximation of the default probability. The
formula fails to take into account several factors that impact CDS spreads such as bid-ask spread and
counterparty risk. Moreover, it assumes that the recovery rate is correct and constant over time.

17. In an April 21, 2011 article in Bloomberg.com by Abigail Moses entitled, Greece, Portugal
Sovereign Credit-Default Swaps Jump to Records, (http://www.bloomberg.com/news/2011-04-
21/greece-portugal-sovereign-credit-default-swaps-jump-to-records.html), the following statement
appears:
Credit-default swaps on Greece jumped 40 basis points to 1,340 basis points according
to CMA, signaling a 68 percent chance of default within five years.

(a) How is the 68 percent chance of default obtained?

The 68 percent chance of default can be obtained from relations that back out default
probabilities from the observed CDS spread. We begin with the equation:

Observed CDS spread in bps / 10,000

= (1 Assumed recovery rate) (Assumed default probability)

Note that in this formula, we use default probability. What this means when using a CDS is not
necessarily a bankruptcy but, more broadly, it is the probability of a realizing a credit event.

Given an assumed recovery rate, then an implied default probability can be obtained by solving
the above equation for the default probability:
Observed CDSspread in bps / 10,000
Implied default probability =
1 Assumed recovery rate
So, for example, if the observed 5-year CDS spread for a corporation is 3,400 basis points and
the assumed recovery rate is 50%, then the implied default probability is 68% as shown below:

Implied default probability = 3,400 / 10,000 = 0.6800 = 68.00%

1 0.50
Notice that the higher the recovery rate assumed, the higher the implied default probability for
a given CDS spread. So, for example, if a 60% recovery rate is assumed, the implied default
probability is 85%.

(b) What assumptions must be made to use this estimate of default?

The 68 percent chance of default was determined from a series of formulas that allows
a computation of the probability of default given assumption about of several factors that impact
CDS spreads. These factors include the bid-ask spread, counterparty risk, and the recovery rate.

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18. Answer the below questions.

(a) Explain how a single-name CDS can be used by a portfolio manager who wants to short
a reference entity.

If a portfolio manager expects that an issuer will have difficulties in the future and wants to take
a position based on that expectation, it will short the bond of that issuer. However, shorting
bonds in the corporate bond market is difficult. The equivalent position can be obtained by
entering into a swap as the protection buyer. More details are provided below.

Credit derivatives (like a single-name CDS) are used by bond portfolio managers in the normal
course of activities to more efficiently control the credit risk of a portfolio and to more efficiently
transact than by transacting in the cash market. For example, credit derivatives allow a
mechanism for portfolio managers to more efficiently short a credit-risky security than by
shorting in the cash market, which is oftentimes difficult to do. For traders and hedge fund
managers, credit derivatives provide a means for leveraging an exposure in the credit market.

For a portfolio manager who engages in a single-name CDS, the manager can note that the
market practice for settlement is physical delivery. With physical settlement the protection buyer
delivers a specified amount of the face value of bonds of the reference entity to the protection
seller. The protection seller pays the protection buyer the face value of the bonds. Because all
reference entities that are the subject of credit default swaps have many issues outstanding, there
will be a number of alternative issues of the reference entity that the protection buyer can deliver
to the protection seller. These issues are known as deliverable obligations. The swap
documentation will set forth the characteristics necessary for an issue to qualify as a deliverable
obligation. Just like for Treasury bond and note futures contracts, the short (in
a single-name CDS) has the choice of which issue to deliver that is specified as acceptable for
delivery. The short will select the cheapest-to-deliver issue, and the choice granted to the short is
effectively an embedded option. From the list of deliverable obligations, the protection buyer
will select for delivery to the protection seller the cheapest-to-deliver issue.

(b) Explain how a single-name CDS can be used by a portfolio manager who is having
difficulty acquiring the bonds of a particular corporation in the cash market.

If the portfolio manager desires a bond it is likely because of the cash flows (associated with the
bond) help the manager match assets and liabilities. Although the ideal bond may be hard to
find and purchase, a single-name CDS can help realize the same desired cash flows. Thus, a
single-name CDS can be used by a portfolio manager who is having difficulty acquiring the
bonds of a particular corporation in the cash market.

19. How are index CDS used by portfolio managers?

By using index CDSs, portfolio managers can gain credit exposure for a standard basket of
reference entities by selling credit protection; a portfolio manager can reduce exposure for a
standard basket of reference entities by buying credit protection. Thus, adjusting index CDS

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positions allows a portfolio manager to alter credit exposure to the bond market. This use of
index CDSs is particularly valuable for portfolio managers of small bond portfolios. Managing a
bond portfolio relative to a bond index involves considerable idiosyncratic risk because all of the
issues in a broad-based bond index cannot be purchased given the large number of issues in a
typical index. One way of gaining exposure to a larger number of reference entities in a bond
sector that comprises a broad-based bond index is via an index CDS.

What is important to note is that although CDSs do offer leveraging opportunities for a portfolio
manager who is permitted to do so, no leveraging need occur if the funds that would have been
used to purchase the reference entities are placed in cash rather than used to purchase other
reference entities. If a portfolio manager uses a derivative for the purpose of leveraging, that can
be easily identified by looking at a portfolios key risk measures. In the case of interest-rate
futures and swaps, this can be seen in the portfolios duration. In the case of CDSs, it will show
up in the portfolios spread duration.

20. How can a client determine if a portfolio manager is using a CDS for leveraging in such
a way as to increase the portfolios risk relative to a bond index?

A credit default swap is an agreement between two parties, one of whom (the protection seller)
will collect periodic payments from the other (the protection buyer). In the event of default in the
underlying bond portfolio, the protection seller will owe the protection buyer a lump sum
payment equivalent to the loss of principal in the bond portfolio. If the protection buyer owns a
portfolio of bonds representing the index, then a credit default swap effectively transfers that
bond exposure to the protection seller and so no additional leverage is introduced into the system
(though this does leave the protection buyer exposed to the risk of the protection seller's potential
to default). If the protection buyer does not own the underlying bond then the CDS serves to
effectively create it synthetically; the protection seller receives payments that are roughly
equivalent to the coupons and is at risk of losing the principal (in the form of a payout) in the
event that the bond issuers default.

What is important to note is that although CDS do offer leveraging opportunities for a portfolio
manager who is permitted to do so, no leveraging need occur if the funds that would have been
used to purchase the reference entities are placed in cash rather than used to purchase other
reference entities. The same point was made in discussing interest rate futures and swaps. If
a portfolio manager uses a derivative for the purpose of leveraging, that can be easily identified
by looking at a portfolios key risk measures. In the case of interest rate futures and swaps, this
can be seen in the portfolios duration. In the case of CDS, it will show up in the portfolios
spread duration.

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