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Credit Derivative

A Credit Derivative is a financial instrument used to moderate or to
assume specific forms of credit risk by hedgers and speculators.

A credit derivative is a derivative whose value derives from the credit
risk on an underlying bond, loan or 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.

The parties will select which credit events apply to a transaction and
these usually consist of one or more of the following:

 Bankruptcy - The risk that the reference entity will become
 Failure to pay - The risk that the reference entity will default on
one of its obligations such as a bond or loan.
 Obligation default - The risk that the reference entity will default
on any of its obligations.
 Obligation acceleration - The risk that an obligation of the
reference entity will be accelerated e.g. a bond will be declared
immediately due and payable following a default.
 Repudiation/moratorium - The risk that the reference entity or a
government will declare a moratorium over the reference entity's
 Restructuring - The risk that obligations of the reference entity
will be restructured.

Where credit protection is bought and sold between bilateral
counterparties this is known as an unfunded credit derivative.


If the credit derivative is entered into by a financial institution or a
special purpose vehicle (SPV) and payments under the credit derivative
are funded using securitization techniques, such that a debt obligation
is issued by the financial institution or SPV to support these obligations,
this is known as a funded credit derivative.

This synthetic securitization process has become increasingly popular
over the last decade, with the simple versions of these structures being
known as synthetic CDOs; credit linked notes; single tranche CDOs, to
name a few. In funded credit derivatives, transactions are often rated
by rating agencies, which allows investors to take different slices of
credit risk according to their risk appetite.


Market Size And Participants
Local banks can take advantage of their informational edge in terms of
assessing the default risk and recovery rates in their regional market.

Credit default products are the most commonly traded credit
derivative product and include unfunded products such as Credit
Default Swaps and funded products such as Collateralized Debt

The International Swap and Derivatives Association reported in April
2007 that total notional amount on outstanding credit derivatives was
$35.1 trillion with a gross market value of $948 billion.

As reported in Times Sept. 15.08 "Worldwide credit derivatives market
is valued at $62 trillion". Although the credit derivatives market is a
global one, London has a market share of about 40%, with the rest of
Europe having about 10%.

The annual growth rate for credit derivatives is 75% from $26.0 trillion
at mid-year 2006. Credit derivatives have been growing at an annual
rate of nearly 100% over the past 3-4 years.

The primary purpose of credit derivatives is to enable the efficient
transfer and repackaging of credit risk.

Banks in particular are using credit derivatives to hedge credit risk,
reduce risk concentrations on their balance sheets, and free up
regulatory capital in the process

These products are particularly useful for institutions with widespread
credit exposures. The main market participants are banks, hedge
funds, insurance companies, pension funds, and other corporates.


Growth in Credit Derivatives (as per British Bankers
Association - Credit Derivatives Report 2006)


Banks 1% 1% Securities Firms 3% 1% 6% Insurance 7% Companies Corporations 18% Hedge Funds 63% Mutual Funds Pension Funds Government/Expo rt Credit Agencies 10 .Market Structure with regards to buyers of Credit Derivatives.

Market Structure with regards to sellers of Credit Derivatives. 11 .

The advantage of this to the protection buyer is that it is not exposed to the credit risk of the protection seller. Funded credit derivative products include the following products: • Credit linked note (CLN) • Synthetic Collateralized Debt Obligation (CDO) • Constant Proportion Debt Obligation (CPDO) 12 . An unfunded credit derivative is a bilateral contract between two counterparties. Credit Derivatives provide a more efficient way to replicate in a derivative form the credit risks that would otherwise exist in a standard cash instrument Credit derivatives are fundamentally divided into two categories: Funded Credit Derivatives and Unfunded Credit Derivatives. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. Unfunded credit derivative products include the following products:  Credit default swap (CDS)  Total return swap  First to Default Credit Default Swap  Portfolio Credit Default Swap  Secured Loan Credit Default Swap  Credit Default Swap on Asset Backed Securities  Credit default swaption  Recovery lock transaction  Credit Spread Option  CDS index products  Constant Maturity Credit Default Swap (CMCDS) A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. Types Of Credit Derivatives. In their simplest form. where each party is responsible for making its payments under the contract (i.e.

it agreeing to restructure a covered obligation or a repudiation or moratorium being declared over any covered obligation. in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. If any of these events occur and the protection buyer serves a credit event notice on the protection seller detailing the credit event as well as (usually) providing some publicly available information validating this claim. A credit default swap. The credit default swap will reference the creditworthiness of a third party called a reference entity this will usually be a corporate or sovereign. then the transaction will settle. its failure to pay in relation to a covered obligation. This product represents over thirty percent of the credit derivatives market. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction. perhaps its bonds and loans. The credit default swap will relate to the specified debt obligations of the reference entity. which fulfill certain pre-agreed characteristics. • Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI) Key Unfunded Credit Derivative Products Credit Default Swap The credit default swap or CDS has become the cornerstone product of the credit derivatives market. 13 . The relevant credit events specified in a transaction will usually be selected from amongst the following: The bankruptcy of the reference entity. it defaulting on an obligation or that obligation being accelerated.

in the case of a physically settled transaction.This means that. a relevant obligation of the reference entity will be valued and the protection seller will pay the protection buyer the full face value of the reference obligation less its current value (i. the principles remain the same. The protection buyer does not need to own an underlying obligation of the reference entity. The protection seller has no recourse to and no right to sue the reference entity for recovery. the protection buyer can deliver an amount of the reference entity's defaulted obligations to the protection seller. compensating the protection buyer for the decline in the obligation's creditworthiness).e. including where there is a basket or portfolio of reference entities. The protection buyer does not need to suffer a loss. The product has many variations. 14 . Credit default swaps have unique characteristics that distinguish them from Insurance products and Financial guaranties. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities. in return for their full face value (notwithstanding that they are now worth far less). although fundamentally. In the case of cash settled transaction.

e. The payments are based upon the same notional amount. it isolates both credit risk and market risk. The essential difference between a total return swap and a credit default swap is that the credit default swap provides protection against specific credit events. widening of credit spreads or anything else i. 15 . as with a vanilla Interest Rate Swap. The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet. and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset. whether default. Typically. The total return swap protects against the loss of value irrespective of cause. index or basket of assets. one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset. while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset. The reference asset may be any asset. Total Return Swap A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract.

The definition of the relevant credit events must be negotiated by the parties to the note. or rating change. 16 . Key Funded Credit Derivative Products Credit Linked Notes In this example coupons from the bank's portfolio of loans are passed to the SPV which uses the cash flow to service the credit linked notes. change in credit spread. which may be a default. A credit linked note is a note whose cash flow depends upon an event.

maturity. but does not have to be. an investment fund manager will purchase such a note to hedge against possible down grades. a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. which have a credit dimension. the bank receives some recompense if the reference credit defaults. Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. However. • Credit-linked notes CLN: Credit-linked note is a generic name related to any bond whose value is linked to the performance of a reference asset. There are several different types of securitized product. a CLN is an on-balance-sheet asset. Typically. Through the use of a credit default swap. their investments will suffer even if the country is still performing well. CLN is a generic name related to any bond whose value is linked to the performance of a reference asset. Here we are going to provide an overview rather than a detailed account of these instruments. or loan defaults. issued by a well-rated borrower. redemption). packaged with a credit default swap on a less creditworthy risk. as it will not need to reimburse all or part of the note if a credit event occurs. This link may be through the use of a credit derivative. or assets. If the bank runs into difficulty. For example. from the point of view of investors. which means the CLN investor receives an enhanced coupon. This link may be through the use of a credit derivative. From the bank's point of view. the risk profile is different from that of the bonds issued by the country. but does not have to be. 17 .A CLN in effect combines a credit-default swap with a regular note (with coupon. Given its note like features. or assets. The credit rating is improved by using a proportion of government bonds. The most basic CLN consists of a bond. this achieves the purpose of reducing its exposure to that risk. in contrast to a CDS.

• Collateralized bond obligations CBO: Bond issued against a pool of bond assets or other securities. to the CLNs themselves. 18 . It is referred to in a generic sense as a CDO • Collateralized loan obligations CLO: Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO CDO refers either to the pool of assets used to support the CLNs or. confusingly. • Collateralized debt obligation CDO: Generic term for a bond issued against a mixed pool of assets.

Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. This exposure is sold in slices of varying risk or subordination . Collateralized Debt Obligations (CDO) Collateralized debt obligations or CDOs are a form of credit derivative offering exposure to a large number of companies in a single instrument. These CDOs are commonly known as CDOs-squared. 19 . Alternatively in a synthetic CDO. A synthetic CDO is also referred to as CSO. In a cash flow CDO. the underlying credit risks are bonds or loans held by the issuer. the exposure to each underlying company is a credit default swap.each slice is known as a tranche.

e. The incentive may be indirect.. 20 . Risks Risks involving credit derivatives are a concern among regulators of financial markets. These backlogs pose risks to the market (both in theory and in all likelihood) and they intensify other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. academics have not only consulting incentives. and highlighted the growing backlog of confirmations for credit derivatives trades. but also incentives in keeping open doors for research.g. The US Federal Reserve issued several statements in the Fall of 2005 about these risks.

however. Of late. presupposes the existence of a sound regulatory setup to address the legal and documentation issues involving credit derivative transactions. What about the Indian market? India has yet to realize the power of the credit derivative market. Credit derivatives. This gap. This. can not only supplement the ongoing process of securitization but also help reduce the inefficiencies in the existing loan market. if introduced. mutual funds and corporate sector in these transactions. Reserve Bank of India has come out with a draft proposal in this regard which has recognized that though banks are dominant players in the loan market and thus are substantially exposed to credit risk. can substantially be bridged through the introduction of credit derivatives which can involve other dominant market players such as insurance companies. the market has not provided provide adequate protection against the credit risk to commercial banks. as observed by RBI. 21 .

increase risk to credits they cannot source in the cash market. The rapid growth of this market is largely attributable to the following features of credit derivatives: Credit derivatives provide an efficient way to take credit risk:. investors have access to a variety of structures. and credit risk (constituting both the risk of default and the risk of volatility in credit spreads). or managing exposure to credit. Credit derivatives provide ways to tailor credit investments and hedges:. The Importance Of Credit Derivatives. A corporate bond represents a bundle of risks including interest rate. CDS that reference senior secured. Credit derivatives have been widely adopted by credit market participants as a tool for investing in. such as baskets and tranches that can be used to tailor investments to suit the investor’s desired risk/return profile. investors may customize tenor or maturity. currency (potentially). First. Through the CDS market. and preferred stock (PCDS) commonly trade. the primary way for a bond investor to adjust his credit risk position was to buy or sell that bond. syndicated secured loans (LCDS). consequently affecting his positions across the entire bundle of risks. 22 . allowing investors to express views on different parts of a company’s capital structure.Credit default swaps represent the cost to assume “pure” credit risk.Credit derivatives provide users with various options to customize their risk profiles. investors may customize currency exposure. while CDS often refer to a senior unsecured bond. and Second. Credit derivatives provide the ability to independently manage default and interest rate risks. or benefit from relative value transactions between credit derivatives and other asset classes. Before the advent of credit default swaps. Additionally.

credit derivative desks typically hold an inventory of protection (short risk). As buyers of the convertible bond purchase protection. and may seek to hedge this risk using credit default swaps. 23 . Thus. For example. and equity-linked market participants transact in the credit default swap market.The credit derivative market is able to provide liquidity during periods of market distress (high default rates). Credit derivatives provide liquidity in times of turbulence in the credit markets:. Before the credit default swap market.Credit derivatives can serve as a link between structurally separate markets:. which may be better positioned to sell protection (long risk) and change their inventory position from short risk to neutral. investors can reduce long risk positions by purchasing protection from credit derivative desks. equity. the change in CDS spreads may cause bond spreads to widen as investors seek to maintain the value relationship between bonds and CDS. However. In distressed markets. the credit default swap market will often react faster than the bond or loan markets to news affecting credit prices. investors buying newly issued convertible debt are exposed to the credit risk in the bond component of the convertible instrument. a holder of a distressed or defaulted bond often had difficulty selling the bond–even at reduced prices.Bond. the CDS market can serve as a link between structurally separate markets. Because of this central position. This has led to more awareness of and participation from different types of investors. As a result. This spread change may occur before the pricing implications of the convertible debt are reflected in bond market spreads. having bought protection through credit default swaps. loan. they are often unwilling to purchase bonds and assume more risk in times of market stress. In contrast. This is because cash bond desks are typically long risk as they own an inventory of bonds. spreads in the CDS market widen.

whereby the "buyer" or "fixed rate payer" pays 24 . the CDS market creates natural buyers of defaulted bonds. rather than the particular liquidity or term needs of a borrower. therefore. In contrast. Credit Default Swaps. risk managers can short specific credits or a broad index of credits. This confidentiality enables risk managers to isolate and transfer credit risk discreetly. Consequently. either as a hedge of existing exposures or to profit from a negative credit view. the terms of the credit derivative transaction (tenor. as protection holders (short risk) buy bonds to deliver to the protection sellers (long risk). CDS markets have. led to increased liquidity across many credit markets. without affecting business relationships. A Credit Default Swap (CDS) is a credit derivative contract between two counterparties. a loan assignment through the secondary loan market may require borrower notification. Credit derivative transactions are confidential:. Since the reference entity is not a party to the negotiation. seniority. a short position can be easily achieved by purchasing credit protection. the reference entity whose credit risk is being transferred is neither a party to a credit derivative transaction.As with the trading of a bond in the secondary market.While it can be difficult to borrow corporate bonds on a term basis or enter into a short sale of a bank loan. nor is even aware of it. and compensation structure) can be customized to meet the needs of the buyer and seller. Furthermore. Credit derivatives provide an efficient way to short a credit:. and may require the participating bank to assume as much credit risk to the selling bank as to the borrower itself.

Credit default swaps allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits). The buyer of a credit swap receives credit protection. and the "seller" of protection agrees to make a payment to compensate the buyer for losses incurred upon the occurrence of any one of several specified "credit events. as it can be used by a debt holder to hedge. whereas the seller of the swap guarantees the credit worthiness of the product. the risk of default is transferred from the holder of the fixed income security to the seller of the swap. A swap designed to transfer the credit exposure of fixed income products between parties. The "buyer" of protection pays a premium for the protection. or insure against a default under the debt instrument. If a credit event occurs. the typical contract either settles by delivery by the buyer to the seller of a (usually defaulted) debt obligation of the reference entity against a payment by the seller of the par value ("physical settlement") or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. By doing this. a credit default swap can also be used for speculative purposes and is not generally considered insurance for regulatory purposes. typically determined in an auction ("cash settlement"). A credit default swap resembles an insurance policy. However.periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default or "credit event" in respect of a third party or "reference entity". because there is no requirement to actually hold any asset or suffer a loss." 25 .

the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap. Bank A Buyer 26 .For example. should the bond default in its coupon payments.

The use of more efficient hedging strategies. 27 . Credit derivatives allow market makers to hold their inventory of bonds during a downturn in the credit cycle while remaining neutral in terms of credit risk. While banks remain important players in the credit derivatives market.9 trillion in December 2005) and by the end of 2007 there were an estimated USD 45 trillion worth of Credit Default Swap contracts.  Banks and loan portfolio managers:. To this end. the Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from 882 reporting banks to be $5. thus reducing the amount of capital needed to satisfy regulatory requirements. trends indicate that asset managers should be the principal drivers of future growth. 2006.472 trillion at the end of March. JP Morgan and many other dealers have integrated their CDS trading and cash trading businesses.  Market makers:. Over the last few years. participants’ profiles have evolved and diversified along with the credit derivatives market itself. Market participants Credit default swaps are the most widely traded credit derivative product and the Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42. Banks continue to use credit derivatives for hedging both single-name and broad market credit exposure. including credit derivatives. They developed the CDS market in order to reduce their risk exposure to companies to whom they lent money or become exposed through other transactions.In the past.9 trillion in December 2006 ($13. In the US. has helped market makers trade more efficiently while employing less capital. market markers in the credit markets were constrained in their ability to provide liquidity because of limits on the amount of credit exposure they could have to one company or sector.Banks were once the primary participants in the credit derivatives market. up from $28.6 trillion in June 2007.

such as a particular maturity. hedge funds have continued to increase their presence and have helped to increase the variety of trading strategies in the market.  Insurance companies:.Since their early participation in the credit derivatives market. or the regulatory framework that allows some insurance companies to enter into credit default swaps) or credit-linked notes. Additionally. Hedge funds:. correlation.The participation of insurance companies in the credit default swap market can be separated into two distinct groups: 1) life insurance and property & casualty companies and 2) Mono lines and Re insurers. Mono lines and 28 . or to provide a structural feature they cannot find in the bond market. hedge funds have been the primary users of relative value trading opportunities and new products that facilitate the trading of credit spread volatility. many funds now use credit default swaps as the most efficient method to buy and sell credit risk.  Asset managers:. the emergence of a liquid CDS index market has provided asset managers with a vehicle to efficiently express macro views on the credit markets. While hedge fund activity was once primarily driven by convertible bond arbitrage. an asset manager might purchase three-year protection to hedge a ten-year bond position on an entity where the credit is under stress but is expected to perform well if it survives the next three years. Also.Asset managers are typically end users of risk that use the CDS market as a relative value tool. the ability to use the CDS market to express a bearish view is an attractive proposition for many. and recovery rates. Life insurance and P&C companies typically use credit default swaps to sell protection (long risk) to enhance the return on their asset portfolio either through Replication (Synthetic Asset) Transactions ("RSATs". Finally. For example.

Some corporations invest in CDS indices and structured credit products as a way to increase returns on pension assets or balance sheet cash positions. In some cases. Finally. to this end. the greater liquidity. corporations are focused on managing funding costs.Corporations use credit derivatives to manage credit exposure to third parties. Re insurers often sell protection (long risk) as a source of additional premium and to diversify their portfolios to include credit risk.  Corporations:. transparency of pricing and structural flexibility of the CDS market make it an appealing alternative to credit insurance or factoring arrangements. many corporate treasurers monitor their own CDS spreads as a benchmark for pricing new bank and bond deals. 29 .

the dealer is generally the calculation agent. CDS written on North American investment grade corporate reference entities. must be supported by publicly available information delivered along with a credit event notice. the protection seller is generally the calculation agent. and a reference obligation. This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided 30 . It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that. The period over which default protection extends is defined by the contract effective date and scheduled termination date. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. usually an unsubordinated corporate bond or government bond. whereas trades referencing North American high yield corporate reference entities typically do not. By market convention. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary. negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings. European corporate reference entities and sovereigns generally also include 'restructuring' as a credit event. although not always. in contracts between CDS dealers and end-users. The definition of restructuring is quite technical but is essentially intended to pick up circumstances where a reference entity. The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations. CDS confirmations also specify the credit events that will trigger a credit event and give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. has debt outstanding. pursuant to the terms of typical contracts. The confirmation typically specifies a reference entity. and for performing various calculation and administrative functions in connection with the transaction. and in contracts between CDS dealers. Terms of a typical CDS contract A CDS contract is typically documented under a confirmation referencing the 2003 Credit Derivatives Definitions as published by the International Swaps and Derivatives Association. a corporation or sovereign that generally. though actual instances of specific events being disputed are relatively rare. as a result of the deterioration of its credit.

Finally. In particular. concerns arising out of Conseco's restructuring in 2000 led to the credit event's removal from North American high yield trades. Typical limitations include that deliverable debt be a bond or Chapter 11 of the United States Bankruptcy Code. that it have a maximum maturity of 30 years. that it be of a standard currency and that it not be subject to some contingency before becoming due. that it not be subordinated. standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. that it not be subject to transfer restrictions (other than Rule 144A). 31 . Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types.

To give an example.000 euros per annum. ABC Corporation may have its credit default swaps currently trading at 265 basis points. and the existence of buyers constrained from buying exotic derivatives. seniority. the cost to insure 10 million euros of its debt would be 265. shortages in a particular underlying instrument. The swap adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. The par premium is calculated so that the contract has zero present value on the effective date. a seller of CDS contracts may quote the premium on a 5 year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. Sellers of CDS contracts will give a par quote for a given reference entity. This is because the expected value of protection payments is exactly equal and opposite to the expected value of the fee payments. If the same CDS had been trading at 7 basis points a year before. Misalignments in spreads may occur due to technical minutiae such as specific settlement differences.g. it would indicate that markets now view ABC as facing a greater risk of default on its obligations. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher. Quotes Of A CDS Contract. The difference between CDS spreads and Z-spreads or asset swap spreads is called the basis. The most important factor affecting the cost of protection provided by a CDS is the credit quality (often proxied by the credit rating) of the reference obligation. In other words. maturity and restructuring e. 32 .

which for convenience we will refer to as the 'probability model'. takes the present value of a series of cash flows weighted by their probability of non-default. and t4. second. third or fourth payment date. so the four premium payments are made and the contract survives until the maturity date. For the purpose of explanation we can imagine the case of a one year CDS with effective date t0 with four quarterly premium payments occurring at times t1. The second model. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds. • the recovery rate. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring. or a default occurs on the first. If the nominal for the CDS is N and the issue premium is c then the size of the quarterly premium payments is Nc / 4. then calculate the present value of the payoff for each outcome. To price the CDS we now need to assign probabilities to the five possible outcomes. Probability model Under the probability model. • the credit curve for the reference entity and • the LIBOR curve. The first. uses a no-arbitrage approach. proposed by Darrell Duffie. t2. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end: either it does not have any default at all. but also by Hull and White. t3. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. Pricing and Valuation There are two competing theories usually advanced for the pricing of credit default swaps. If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. 33 . a credit default swap is priced using a model that takes four inputs: • the issue premium.

given discount factors of δ1 to δ4 is then 34 . At either side of the diagram are the cash flows up to that point in time with premium payments in blue and default payments in red. The calculation of present value. where R is the recovery rate. or it survives without a default being triggered. shown in blue. If the contract is terminated the square is shown with solid shading. in which case a premium payment of Nc / 4 is made.This is illustrated in the following tree diagram where at each payment date either the contract has a default event. The probability of surviving over the interval ti − 1 to ti without a default payment is pi and the probability of a default being triggered is 1 − pi. in which case it ends with a payment of N(1 − R) shown in red.

or mathematically p = exp( − s(t)Δt) where s(t) is the credit spread zero curve at time t. p3. p4 can be calculated using the credit spread curve. To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give 35 . p2. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time. The probability of no default occurring over a time period from t to t + Δt decays exponentially with a time-constant determined by the credit spread. Default Payment Description Premium Payment PV Probability PV Default at time t1 Default at time t2 Default at time t3 Default at time t4 No defaults The probabilities p1.

36 . and Hull and White. If a bond has a spread of 100. However the Duffie approach is frequently used by the market to determine theoretical prices. which may invalidate the no-arbitrage assumption. No-arbitrage model In the 'no-arbitrage' model proposed by both Duffie. this is not always the case. Duffie uses the LIBOR as the risk free rate. the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. However owing to inefficiencies in markets. The difference between the theoretical model and the actual price of a credit default swap is known as the basis. Under the Duffie construct. whereas Hull and White use US Treasuries as the risk free rate. it is assumed that there is no risk free arbitrage. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default). then a CDS contract should trade at 30. and the swap spread is 70 basis points.

the pension fund pays 2% of 10 million ($200. the pension fund would stop paying the quarterly premium. Hedging Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. In order to manage the risk of losing money if Risky Corporation defaults on its debt. or to speculate on changes in credit spreads. credit default swaps can be used to hedge existing exposures to credit risk. If Risky Corporation does not default on its bond payments. its risk of loss in a default scenario is eliminated. the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation. the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.000 to Derivative Bank.000) in quarterly installments of $50. the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million that trades at 200 basis points. If Risky Corporation defaults on its debt 3 years into the CDS contract. and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity. a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. Uses Of Credit Derivative Swaps. Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years. In return for this credit protection. Though the protection payments reduce investment returns for the pension fund. 37 . Like most financial derivatives. For example.

But these pricing differences are amplified compared to bonds. Swap prices typically decline when creditworthiness improves. If the company does not default. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity. and rise when it worsens. Alternatively.000. Like the bonds themselves. you would receive the entire $1 million and make a profit of $100. with a value equal to the notional amount of the CDS contract. if a company has been having problems. it might be possible to buy the debt for $900. the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. one would make a profit of $100.000 from another party if that party is concerned that the company will not repay its debt. If the company has $1 million worth of bonds outstanding. It is also possible to buy and sell credit default swaps that are outstanding.000. one could enter into a credit default swap with the other investor. Therefore someone who believes that a company's credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds (although encountering a greater loss potential). by selling credit protection and receiving a premium of $100. Speculation Credit default swaps give a speculator a way to make a large profit from changes in a company's credit quality. 38 .000 without having invested anything. it may be possible to buy the company's outstanding debt (usually bonds) at a discounted price. For example. If the company does in fact repay the debt.

then the loss to investors holding the bonds would be $600 million. generate returns close to LIBOR but with additional volatility. in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. credit derivatives can also amplify those risks. the notional value of such contracts would be expected to be less than the size of the outstanding debt as the majority of such debt will be owned by investors who are happy to absorb the credit risk in return for the additional spread or risk premium. no major counterparty in the world's biggest financial market had ever gone under. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction. though. Criticisms The collapse of Lehman Brothers has triggered an enormous crisis in derivative markets. In the meantime. Long term investors would consider such returns to be of limited value." In Berkshire Hathaway's annual report to shareholders in 2002. When the CDS have been made for purely speculative purposes. company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. However speculators may profit from these differences and therefore improve market efficiency by driving the price of bonds and CDs closer together. the counterparties record profits and losses -often huge in amount. and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars. However the loss to credit default swap sellers would be $6 billion. 39 . he said. so it their current earnings statements without so much as a penny changing hands. and recovery is 40 cents on the dollar. at least theoretically. also states that he uses derivatives to hedge. however. A major counterparty failure threatens the delicate web of trading in securities that are gargantuan in dollar amounts but totally lacking in transparency to the public. For instance. The range of derivatives contracts is limited only by the imagination of man (or sometimes. their ultimate value also depends on the creditworthiness of the counterparties to them. Prior to the firm's spectacularly swift demise. madmen). before a contract is settled. "Unless derivatives contracts are collateralized or guaranteed." The same report. A bond hedged with CDS will. The market for credit derivatives is now so large. If such a company were to default. If the CDS were being used to hedge. in addition to spreading risk.

However CDS premiums can act as a good barometer of company's health. For example the credit spread of Bear Stearns widened significantly in the period immediately prior to being bailed out by the Fed and JP Morgan providing equity investors with advance warning of impending problems at the company. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default. 40 .

Operational Issues In Settlement In the US. In addition. 2006. As of January 31. Delphi Corporation. Dura Operating Corporation and Quebecor. the settlement and processing of a CDS contract is currently the subject of concern by the US Federal Reserve. Successful auction protocols have been applied following credit events in respect of Collins & Aikman. Dana Corporation. the Federal Reserve obtained a commitment by 14 major dealers to upgrade their systems and reduce the backlog of "unprocessed" CDS contracts. after these entitities were placed in conservatorship. In 2005. Calpine Corporation. Delta Air Lines and Northwest Airlines. 41 . ISDA is also using a protocol for the settlement of contracts on Fannie Mae and Freddie Mac debt. growing concern over the sheer volume of CDS contracts potentially requiring physical settlement after credit events for names actively traded in the single-name and index-trade market where the notional value of CDS contracts dramatically exceeds the notional value of deliverable bonds has led to the increasing application of cash settlement auction protocols coordinated by ISDA. the dealers had met their commitment and achieved a 54% reduction.

42 . Note that the actual terms of a LCDS transaction are defined by the confirmation of that transaction only. with several modifications to address the unique nature of the loan market. These include: The ability to implement a bullish view (sell LCDS protection) without having to access the primary or secondary market for cash loans. The ability to trade cross-asset views such as a view on the senior debt spread versus loan spread. LCDS allows investors to take advantage of benefits and risks similar to those available to investors in standard CDS. Loans have historically been a long-only cash asset. herein. with little or no ability for participants to go short risk or take on risk synthetically. The ability to create levered portfolios of secured risk. We discuss these differences. Loan CDS(LCDS) The emergence of a standardized secured loan CDS (LCDS29) market is a major development in the evolution of the loan market. The ability to hedge or implement bearish views on loans (buy LCDS protection) and be short risk in what has traditionally been a long-only market. LCDS contracts are based on the standard corporate CDS contract. and this research note forms no part of that document. along with modifications made to LSTA documents. The ability to implement curve shape positions and views once the market develops and a LCDS spread curve becomes available.

LCDS also serves as an alternative to proxy hedging loan exposure in the bond or standard corporate CDS market – a hedge which introduces spread correlation. Structured credit vehicles: In the current market. we expect cash CLOs to sell protection (long risk) as an alternative means to access the loan market. Structured credit investors: LCDS gives investors the ability to dynamically hedge single loans in cash CLOs or synthetic structured credit portfolios. banks and hedge funds are the most active users of LCDS. 43 . and index-tranched trades. LCDS also provides the potential for fully synthetic managed. Market Participants As in standard CDS. basis. where allocations to cash loans continue to be squeezed by excessive demand. Total return funds: Total return funds can use LCDS to effectively create levered portfolios of secured risk. LCDS also helps CLOs avoid high dollar prices in cash loans trading in the secondary market (high dollar prices decrease initial over collateralization ratios). recovery. We also anticipate selective positioning on spread widening or protective single-name hedging. and other risks. and some new structures are already incorporating synthetic buckets. bespoke. Participants include: Banks and other lenders: LCDS provides an attractive opportunity for discrete hedging as an alternative to selling cash loans.

preferred stock. 44 .Capital Structure investors: Capital structure investors can express views on secured loans in relation to other securities including unsecured bonds. or common stock. long a subordinate security (in cash or derivative form). Typical trades include selling LCDS protection (long risk) versus short a subordinate security (in cash or derivative form) or buying LCDS protection (short risk) vs.

The NOPS Fixing Date is set at 3 business days after the notice of physical settlement is delivered. however.Settlement Following A Credit Event Settlement Timing Like in traditional CDS contracts. revolving loans. or other loans that trade as syndicated secured of equal or higher priority. The protection buyer. In the case of revolvers. What loans are deliverable if there is a credit event? After a credit event. Upon receipt of these documents. will not be forced to realize a loss on the difference between par and the loan price. the protection seller has 3 business days to execute and return the documents. 45 . the protection buyer has 30 days following a credit event notice to declare their intent to settle physically by delivering a notice of physical settlement (NOPS). a seller of protection who is delivered revolving loans is liable for any future draws on the revolver. Term loans. are deliverable. and multi-currency loans are all deliverable. the protection buyer must deliver all necessary documents to effect physical settlement. cash loans may trade above par after a credit event. although in nearly all cases the ability to draw on a revolver is eliminated upon a default. loans on the secured list. Loans trading above par after a credit event In some cases. As soon as practicable after the NOPS Fixing Date.

A protection buyer is not stepping up if he does not receive payments from the grantor of the original participation. but holds a participation from another party). the protection seller takes a participating interest in the existing lender’s commitment. and we anticipate that a significant proportion of contracts will be cash settled. In this scenario. although (like corporate CDS) they do not preclude bilateral settlement agreements or participation in any cash settlement or netting protocols that may be developed. The physical settlement process calls for settlement by: Assignment: In an assignment. and lender under. with the protection buyer remaining the title holder of. and will receive payments only to the extent the protection buyer receives payment from his upstream counterparty. Participation: If the loan cannot be transferred to the seller via assignment due to lack of necessary consent or other failure to meet requirements under the credit agreement. Settlement may also occur by sub participation (the protection buyer does not own the loan. subject to the modifications discussed in the following section of this note. Assignments typically require the consent of the borrower and agent. Physical settlement is governed by the documents customarily used by the Loan Syndications and Trading Association (LSTA) that are current at the notice of physical settlement fixing date. settlement may occur by participation. In a participation. the loan. Settlement Mechanics Like traditional CDS contracts. the protection seller will receive a participation. the protection seller becomes a direct signatory to the loan agreement. 46 . LCDS documents call for physical settlement.

g. the buyer does not pay the seller even if the loan trades above par following a credit event). Accordingly. or if the seller of protection elects to cash settle. settlement may occur by partial cash settlement. lack of necessary consent).e. Conclusion 47 . The cash settlement amount will be the difference between 100% and the loan price as determined from dealer quotations. and cannot be negative (i. the protection seller is taking credit risk of more than just the protection buyer. Cash Settlement: If settlement cannot be completed due to failure to meet requirements under the credit agreement (e.

I would like to conclude my project by saying Credit Derivatives -Credit Default Swaps are a very important hedging tool but could also have a multiplier effect in a sever Financial Default takes place. which would make it difficult to achieve the financial security we aim at by hedging our positions. In this regards I believe that Credit Derivatives are a boon to the financial markets. Bibliography 48 . On the other hand I would also like to point out that if there is a Credit Default the impact will multiply. We have seen the adverse impact of the financial defaults in USA. We always want our financial transactions should be clear and not a complex web.In India we have always garnered security and have always promoted Financial instruments that not only bring about financial stability but also have a very sound authenticity. as they cover our risk of defaults to the maximum extent.

org www.Credit Derivatives Handbook 2006 www. www.wikipedia. P. Web 49 .investopedia.bba. www.