Krea University

IFMR GBS

DRM – Credit Derivatives

Aug 2022
Objective
• Learn different types of Credit Derivatives
• Understand the life cycle of Credit Derivatives
• Understand the Factors needed to price different Credit Derivatives
• Understand the use of Credit Derivatives
What is a Credit Derivative?
An instrument that allows the credit risk from an Asset (e.g. Loans, Corporate
Debt, Bonds, Securities, Trade Receivables) to be traded to another party.

How?
❖ Insurance against risky credit positions.

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How to Hedge a Risk ?
Premium (Spread)

Protection Buyer
(Pension Funds,
Mutual funds etc.)
Default Payment
Credit Events: Protection Seller
- Bankruptcy (Investment Bank)
-Failure to pay
-Restructuring

Credit Risk

Reference Obligation Plain Vanilla Credit Default Swap

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Credit Event - Example

Premium 100 basis p.a.

Default Payment
Protection Buyer
Protection Seller

-Bond Maturity = 1 Year Term

-Reference Assets = $1M
-Bond Face value = $100
-Recovery Rate 40% on Face Value i.e. $40
-Credit Event = Failure to pay
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Settlement
▪ Annual Premium to Protection Seller: $10,000
▪ $1m x 1% (100 Basis)
▪ (1 basis pt = 1/100*1%)

▪ Default Payment to Protection Buyer: $600,000

= Notional Value x [(Par - Recovery)] / 100]
= $1m x [(100-40) / 100]

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What are the Credit Events?
Financial Difficulty is referred to as a ‘credit event’, or a ‘default’. A credit Default swap contract is ‘triggered’ if a
credit event occurs, meaning the Protection Seller has to pay Protection buyer.
There are three broad categories of credit events that are put into the documentation of credit default swap
contracts:

▪ Bankruptcy:
If a company gets bankrupt then that is a clear indicator that the company is in serious financial difficulty and
that the bondholders may not get all their money back. This is an obvious thing to have trigger the payment in
a CDS contract.
▪ Failure To Pay:
If a company fails to make payments it should be making, including coupon payments on the bonds, then this
can be documented as a credit event.
▪ Restructuring:
This is where a company changes the payment schedules it makes on its bonds, usually with the agreement of
the bondholders. It’s usually not to the bondholders advantage when this happens, and hence CDS contracts
can be documented to cover this kind of restructuring as a credit event.

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Types of Credit Derivatives
▪ Unfunded Credit Derivatives:
It is a contract between two parties where each is responsible of making the payments under the
contract. These are termed as unfunded as the seller makes no upfront payment to cover any
future liabilities. The seller makes any payment only when the credit events occurred. Ultimately
the buyer takes the credit risk on whether the seller will be able to pay any cash / physical
settlement amount.

▪ Funded Credit Derivatives:

In this type, the party that is assuming the credit risk makes an initial payment that is used to
settle any credit events that may happen going forward. Thereby, the buyer is not exposed to
the credit risk of the seller. These kinds of transactions generally involve SPVs for issuing / raising
a debt obligation which is done through the seller.

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Unfunded Credit Derivative

▪ Credit Default Swap (CDS)

▪ Credit Default Swap on Single
▪ Credit Default Swap on Basket
▪ Credit Default Index Swap (CDIS)
▪ Credit Default Index Swap Tranche

▪ Total Return Swap (TRS)

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Credit Default Swap (CDS) - Single
▪ CDS are over-the-counter (OTC) transactions

▪ Before trading, institutional investors and dealers enter into an ISDA Master Agreement, setting up the legal
framework for trading. Each contract is defined by:
I) A Reference Entity: the underlying entity on which one is buying/selling protection on;
ii) A Reference Obligation: the bond or loan that is being “insured”
iii) A Term/Tenor
iv) A Notional Principal: Notional value is the total value of a leveraged position's assets
v) Credit Events: the specific events triggering the protection seller to pay the protection buyer – The
defined events are bankruptcy, failure to pay, debt restructuring, and obligation default

▪ Types of CDS contracts traded:

CDS: The underlying reference entities and obligations are bonds.
LCDS: Loan-only CDS refers to contracts where protection is bought and sold on loans.
, MCDS: The reference entity is a municipality, and the reference obligation a municipal bond.
ABCDS: CDS on Asset-Backed Securities. 10
Credit Default Swap (CDS)
CDS: Settlement Mechanism

Settlement Type Description

Cash Settlement The termination payment is calculated as the

difference between nominal value of the reference
asset and market value of the asset at the time of
credit event
Physical Settlement In this case buyer delivers reference asset to the seller
and seller gives face value of the reference asset to the
buyer. The contract can specify number of alternative
assets which the buyer can deliver. These are known as
“deliverable obligations”. In such cases buyer gives
“cheapest to deliver bond” to the seller

11 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap (CDS) : Valuation

The following assumptions are made in the valuation of a CDS

• Payments on CDS happens only once in a year at the end of the year
• Default always happens half way through the year
• Risk free rate is 5%
• Recovery rate is 40%
• Principal is $1
• Default probability is 2% each year

12 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap (CDS) : Valuation
The valuation of a CDS can be done in a 4 step process

• The CDS has 2 legs – 1.Premium payment 2. Pay-off in case of credit event
• Step 1 – calculate default and survival probability for the given period
• Step 2 - Calculate the present value (PV) of premium payment leg on the CDS. This includes annual
premium payment made and accrual payment in case a event happens half way through the year
• Step 3 – Calculate the PV of expected pay-off leg. This will be based on default probability and
recovery rate which has been assumed.
• Step 4 – In the final step, these two PVs are equated to arrive at the CDS spread.
• The valuation process is explained in detail in next few slide

13 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap (CDS)
Valuation of CDS:
Step 1 – Calculation of default and survival probability
The table depicting the probability of default is given below. Assume that probability of default in 1 st
year is 2% and probability of survival is 98%. Similarly the probability of default in 2 nd year is =.02*.98
= .0196 and probability of survival is .98*.98=.9604.
The table for 5 years is given below

Year Default Probability Survival Probability

1 .0200 .9800
2 .0196 .9604
3 .0192 .9412
4 .0188 .9224
5 .0184 .9039

14 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

continued…
Credit Default Swap (CDS)
Valuation of CDS
Step 2 – Calculating the PV of premium payment leg
Table 2 gives the PV of expected payments made on the CDS.The payments are made at the rate of p per year. For example
in 3rd year there is .9412 probability that a third payment of p is made. The PV of expected event for 3 rd year will be .9412e-
.05X3 p = 0.8101p (t=3 years, risk free rate = 5%). Similarly PV for other years can be calculated.

Year Survival Expected PV of

Table 2 Probability payment expected
payment
1 .9800 .9800p .9322p
2 .9604 .9604p .8690p
3 .9412 .9412p .8101p
4 .9224 .9224p .7552p
5 .9039 .9039p .7040p
Total 4.0704p

15 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap (CDS)
Valuation of CDS
Step 2 continued – calculating the PV of premium payment leg
Table 3 gives the accrual payment in case of default. Example, there is a .0196 probability that there will be final
accrual payment (even if the credit event happens midway through the year even then .5 premium payment will
be paid) midway through 2nd year. Accrual payment is .5p .The expected accrual payment will be
.0196*.5p=.0098p and its PV will be .0098*.e-.05X1.5 = .0091p and so on.

Year default Expected accrual DF PV of EAP

Probability payment (EAP)
1 .0200 .0100p .9753 .0097p
Table 3
2 .0196 .0098p .9277 .0091p
3 .0192 .0096p .8825 .0085p
4 .0188 .0094p .8395 .0079p
5 .0184 .0092p .7985 .0074p
Total .0426p

16 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap (CDS)
Valuation of CDS
Step 3 – calculating the PV of pay-off leg
Table 4 gives the PV of expected pay-off. For example there is .0192 probability of a pay-off midway through 3rd year. Since
the recovery rate is 40%, the expected pay-off will be .0192*.6* $1 =.0115 (payoff = 1- recovery rate so 1-.4 = .6, $1= our
assumption that notional principal is $1) and the PV of expected pay-off is =.0115*e-.05*2.5 = .0102 and so on. Similarly PV of
other years can also be calculated
Table 4
Year default Recovery Expected Pay- DF PV of EP
Probability Rate off (EP) $
1 .0200 .4 .0120 .9753 .0117
2 .0196 .4 .0118 .9277 .0109
3 .0192 .4 .0115 .8825 .0102
4 .0188 .4 .0113 .8395 .0095
5 .0184 .4 .0111 .7985 .0088
Total .0511

17 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap (CDS)
Valuation of CDS

Step 4 – Equate the PV of premium payment leg and pay-off leg

From Table 2 and 3, we calculate the PV of premium payments leg
Which is 4.0704p +.0426p = 4.1130p
From Table 4 we know that PV of pay-off leg is .0511
We equate the two
4.1130p = .0511
p = .0124
So the CDS spread for the 5 year CDS should be 124 basis points or .0124 times the principal

18 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

CDS Pricing Market Data
• Risk-free Yield Curve – Uses Treasury bills in short term and CG Bonds
in the longer terms

• PD Curve - Probability of Default of the issuer/bond

• Recovery Rate – Given default what is the percentage of the asset

that can be recovered from the issuer Risk-Free

https://ihsmarkit.com/products/single-name-pricing-data.html
Probability of Default by External Ratings
CDS spread and factors affecting it
• Amount paid as a percentage of notional principal to buy protection on an entity is called ‘CDS spread’
• CDS spread is an indication of the market’s risk perception on that particular underlying. If the risk perception
of the entity deteriorates then its CDS spread increases
• Risk perception can deteriorate if credit rating agencies downgrade their rating on a particular entity or there is
some negative news about it
• If the CDS spread increases then the borrowing cost for the firm also increases as the market expects a higher
yield for higher risk
• Investor can convert their corporate bond into a risk-free bond by buying CDS protection on such bonds. For
example, if a corporate bond is giving a yield of 9% and say CDS spread is 200 basis points. Then by buying a
CDS protection, the investor has converted the corporate bond yielding 9% into a risk-free bond yielding 7%
• So, theoretically the CDS spread should be equal to the difference between yield of a corporate bond and a
risk-free bond. If the CDS spread is less than this then the investor can earn more than risk-free rate by buying
the corporate bond and buying CDS protection on that.
• If the CDS spread is not equal to the difference between the yield on corporate bond and the yield on risk-free
bond then arbitrage opportunities arise for investor

21 Presentation Title | IBM Internal Use | Document ID | 26-Sep-22

Credit Default Swap on Basket
▪ A basket default swap is similar to a single entity default swap except that the
underlying is a basket of entities rather than one single entity. There are several
types of basket default swaps. The popular ones are first-to-default, and n-th-
to-default Swap.

▪ A First-to-default swap, whenever an entity in the reference basket defaults, the

buyer stops paying the swap's premium and receives from the seller the
difference between the principal amount of the defaulted entity and the
recovered value. Thereafter, the contract no longer exists.

▪ In an n-th-to-default swap whenever the n-th default occurs in the reference

basket, the buyer stops paying the premium and receives the difference of the
principal amount of the latest (n-th) defaulted entity and the recovered value.
Note that the premium does not stop until the n-th default as long as the
counterparty does not default, even if there are already defaults in the basket. 22
Credit Default Swap on Basket
Premium (Spread)

Default Payment
Protection Buyer
(Pension Funds, Credit Events: Protection Seller
Mutual funds etc.) - Bankruptcy (Investment Bank)
-Failure to pay
-Restructuring

Basket

Reference Reference Reference Reference Reference

Asset 1 Asset 2 Asset 3 Asset 4 Asset 5

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Credit Default Index Swaps (CDIS)
A Brief History:
▪ Credit indices originated in 2001 when JPMorgan launched the JECI and Hydi indices, and Morgan Stanley launched Synthetic
TRACERS. Both firms merged their indices under the Trac-x name in 2003. During the same period, iBoxx launched credit
derivatives indices
▪ In 2004 Trac-x and iBoxx merged to form the CDX in North America and the iTraxx in Europe and Asia.
▪ After being the administrator for the CDX and calculation agent for iTraxx, Markit acquired both families of indices in
November 2007, and owns the iTraxx, CDX, LevX, and LCDX Indices for Derivatives.

iTraxx CDX
Region Europe, Asia and Emerging North America and Emerging
Markets Markets
Credit Event Bankruptcy, Failure to Pay, Bankruptcy, Failure to Pay
Restructuring

Standardized CDIS: Currency EUR, JPY & USD USD, EUR

Reference Entities A liquidity poll decides inclusions A rules-based approach, that takes
and exclusions into account liquidity (as well as
sectors and ratings for high yield
names), determines inclusions and
exclusions

Business Days London and TARGET Settlement USD – New York and London
Day EUR – London and TARGET
Settlement Day
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CDX

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iTraxx

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Main difference between CDS and CDIS
The difference between CDS and CDIS is:
▪ CDS is an Over The Counter (OTC) Credit Derivatives, and credit default swap index is a completely standardized
▪ CDS the premium (Spread) is fixed during the life of the CDS and the Protection buyer is compensated at most once, and
▪ CDIS the premium (Spread) is variable. Whenever a default in the portfolio occurs, the premium notional is reduced by
the loss amount of the defaulted entity and at the same time the protection buyer gets compensated by the lost
amount

Benefits of using CDIS :

▪ Tradability: Credit indices can be traded and priced more easily than a basket of cash bond indices or single name CDS
▪ Liquidity: Significant liquidity is available in indices and has also driven more liquidity in the single name market
▪ Operational Efficiency: Standardized terms, legal documentation, electronic straight-through processing
▪ Transaction Costs: Cost efficient means to trade portions of the market
▪ Industry Support: Credit indices are supported by all major dealer banks, buy-side investment firms, and third parties
(for example, Markit offers transaction processing and valuations services)
▪ Transparency: Rules, constituents, fixed coupon, daily prices are all available publicly.

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What standardized CDS Means …..
A credit default index swap is still a contract that provides a kind of insurance
against a reference entity defaulting on its reference obligations. The main change
that has happened is that credit default swap contracts have been Standardized,
as follows:

▪ Changes to the premium and maturity dates that simplify the mechanics of CDS
trading.
▪ Changes to the processes around identifying whether a credit event has
occurred.
▪ Changes to the processes around what happens when a credit event has
occurred.

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Main Parties involved
▪ Institutional Investors:
Investors who hedge their positions

▪ Licensed Participants:
These participants include banks that trade on their own behalf and provide liquidity for their clients, as well as licensed Swap
Execution Facilities (SWF) - e-Trading Platform

▪ ISDA (International Swaps & Derivatives Association):

To Create a legal documentation such as “ISDA Master Agreement”

▪ Markit:
Markit owns and operates the indices: including licensing, marketing, administration, and calculation. Markit publishes prices daily on
its website

▪ Third Parties:
Third parties have made trading credit indices easier by integrating them into their platform. For example, MarkitSERV, a joint venture
between Markit and DTCC, allows buyside and sellside firms to communicate and confirm trade details with counterparties 29
Credit Events - Settlement
▪ Credit Events result in the triggering of the CDS single name and index contracts. As a consequence a payout occurs from the
seller of protection on the index to the buyer of protection

▪ The ISDA Determinations Committee (DC) for the respective region decides whether a Credit Event has occurred and whether an
auction will be held

▪ A Credit Event in a constituent of the CDS index, a new version of the index is published which assigns a zero percent weight on
the relevant entity. The notional amount on the index trade is reduced by the weight of the name in the index. Assuming 100
names in the index and one default, the new version of the index will contain 99 names and have a revised notional of $9.9
million rather than $10 million

▪ Trades can either be cash settled or physically settled following a Credit Event. Cash Settlement is the default settlement
mechanism for all CDS trades. Cash Settlement is conducted by setting the recovery price in an auction, and the compensation
received by the protection buyer is based on the final agreed auction price
Assuming a recovery of 70 cents on the dollar, all protection buyers are compensated 30 cents in the dollar on the defaulted
name. Assuming that each entity has a 1% weighting in the index, they are compensated 1% * 0.3 multiplied by the notional of
the trade. For a $10m trade, this equals $30,000
Markit and Creditex administer the auction and publish the results

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Total Return Swap (TRS)
▪ TRS is a bilateral transaction between 2 parties, Total Return Swap Payer (TRP) and Total Return
Swap Receiver (TRR). It is also known as Total Rate of Return Swap
▪ TRP is Protection Buyer or Swap Seller, & TRR is Protection Seller or Swap Buyer

Funding Leg
LIBOR + Basis Points (Coupons) and
Capital Loss

Total Return
(Cash Flow Coupon & Principal +
Total Return Payer (TRP) Capital Appreciation – Capital Depreciation) Total Return Receiver (TRR)
(Protection Buyer)
(Protection Seller)
Total Return Leg

Reference Obligation
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Summary
▪ The TRP (Total Return Payer) scarifies one set of expected future returns i.e.
Capital Appreciation, Coupon, Dividend in exchange for another set of assured
future return i.e. LIBOR and BPS Spread PLUS Capital Loss on reference assets.

▪ TRP is able to lock in the value of reference assets and receive additional income
in the form of LIBOR PLUS BPS Spread.

▪ The legal ownership of reference assets continues with TRP till maturity.

▪ It is reflected in his balance sheet.

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Funded Credit Derivative

▪ Credit Linked Note (CLN)

▪ Collateralized Debt Obligation (CDO)

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Credit Linked Notes (CLN)
▪ CLN is a privately placed fund-based instrument, in the form of security receipts, with embedded
Credit Default Swap (CDS) feature
▪ CLN are on balance sheet equivalents of Credit Default Swap (CDS)
▪ CLN transaction is fund based as CLN investors pay cash to CLN Issuer. The Credit Default Swap
(CDS) is non-fund based

CDS
(Protection CASH
CASH Assets Protection Seller)
Owner
Issuer CLN
(Protection
Buyer) -Coupon Payments Investors
ASSETS Premium CLN till maturity ,
Seller -On Maturity
Principal Returned.

Reference Assets
(Bonds, Loans etc.)

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CLN Flow – Example without any Credit Event
▪ Bond owner purchases bond from Bond seller(Originator) for cash that becomes a reference assets.

▪ Bond owner can transfer default risk or credit deterioration risk by obtaining protection from protection
seller through Credit Default Swap (CDS).

▪ CLN Seller (an Investment Bank/SPV) issues CLN as marketable securities, on the basis of reference assets
with similar maturity and principal as that of the reference asset.

▪ CLN Investors get the security receipts and pay cash upfront to the CLN issuer according to term of issue.

▪ CLN issuer makes regular payment of coupon amount to CLN investors till maturity.

▪ If there is no default on reference asset, CLN issuer returns the face value of security receipts to CLN
investors.

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CLN Flow – Example with a Credit Event
▪ If there is default (credit event) on reference asset, the CDS in triggered and CLN seller (Protection
Seller), who is CLN issuer also has to pay value of reference asset to the Bond owner (Protection
Buyer) to discharge CDS obligation.
▪ In return, Bond owner delivers bond to the CLN seller.
▪ CLN Seller delivers the bond to the CLN investors instead of returning cash, it received.

CDS
Pay bond value to meet
(Protection On default, by bond
Bond CDS Obligation CLN
Seller) Issuer, Bond will be
Owner delivered. CLN buyer Investors
(Protection to bear loss.
Buyer) CLN
Delivers reference assets
Seller

Reference Assets
(Bonds, Loans etc.)

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Advantages / Risks of CLN:
Advantages
▪ CLN allows risk distribution to a large number of investors
▪ CLN investors get an additional opportunity of investment
▪ Bond owner gets protection against credit default risk and credit deterioration risk`
▪ CLN seller receives additional income as Protection Seller by way of premium from bond
owner (Protection Seller)

Risks to CLN Investors

▪ Default Risk / Credit deterioration risk relating to reference asset, and
▪ Counterparty Risk of non-payment of coupon or security receipt value by CLN issuer

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Collateralized Debt Obligations (CDO)
▪ CDO are financial tools, structured from fixed income generating assets (reference assets) e.g.
loans, bonds.

▪ The originator who owns the reference assets such as bank, transfer credit risk by selling these
loans to Special Purpose Vehicle (SPV) / Investment Bank.

▪ SPV creates marketable securities. It categorizes these into different categories, according to
risk.

▪ Investor who make investment in these securities fund the CDOs

▪ Repayment /Redemption is collateralized (covered) by cash inflow from the reference asset in
the form of recovery of loans / redemption of bonds.

▪ CDOs Example: Asset Backed Securities (ABS)

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CDO Flow

CASH CASH
Originator
(Bank)
Special
Purpose Right to Investors
Vehicle Cash Flow
(Investment Bank)
Reference Transfer of Risk
Assets &
(Bonds, Right to Cash Flow Risk
Loans etc.)

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Collateralized Debt Obligation (CDO)
A graphical representation of a CDO created from multiple Bonds (1,2,3). The
proceed of these bonds are passed to a SPV. SPV then, transfers the income
generated from these Bonds to various Tranches according on their seniority
Tranche 3
(Senior)
Principal - $70 m
Bond 1
Return - 7%
Bond 2
Bond 3
Tranche 2
(middle)
SPV Principal - $20 m
Return - 12%

Tranche 1
Total Principal (Equity)
$100m Principal - $10 m
Return - 25%

40 Presentation Title | IBM Internal Use | Document Calypso

ID | 26-Sep-22
Training
Benefits of CDOs
Originator:
▪ Funds received can be invested into new loans
▪ Credit risk transferred to investors

SPV (an Investment Bank):

▪ Receives Commission

Investors:
▪ Get additional avenue to invest and get better returns

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