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Understanding CDS, CDO, and IRS Concepts

This document summarizes three financial instruments: credit default swaps (CDS), collateralized debt obligations (CDOs), and interest rate swaps (IRS). It provides examples of how each works. A CDS transfers credit risk of a debt obligation from one party to another. A CDO distributes risk through tranching a portfolio of credit and issuing notes of varying risk levels. An IRS involves an agreement to exchange interest rate cash flows from fixed to floating or between two floating rates.

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87 views13 pages

Understanding CDS, CDO, and IRS Concepts

This document summarizes three financial instruments: credit default swaps (CDS), collateralized debt obligations (CDOs), and interest rate swaps (IRS). It provides examples of how each works. A CDS transfers credit risk of a debt obligation from one party to another. A CDO distributes risk through tranching a portfolio of credit and issuing notes of varying risk levels. An IRS involves an agreement to exchange interest rate cash flows from fixed to floating or between two floating rates.

Uploaded by

rakshaya
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd

CDO,CDS & IRS

By: Fahad Siddiqui


Meenakshi Chettiar
Priyanka Narvekar
CDS
• Credit Default Swap (CDS)
– A contract designed to transfer the credit exposure of
debt obligation between parties.

– The buyer of a credit swap receives credit protection,


whereas the seller of the swap guarantees the credit
worthiness of the underlying security.

– In a CDS the risk of default is transferred from the holder


of the security to the seller of the swap.
Working of CDS

10% p.a Corporation A


Pension Fund
BB Rating
$ 1 Billion

1 % p.a Insurance
on A’s Debt

Insurance Credit Rating


Company (AIG) Agency
AA Rating
CDS Contd..

A B C

$2B 12%
Credit
Rating
$1B 10% Agency
Insurer 1 Insurer 2

Insurance on
1% I.B 2% of $10B B for $10B
2% = $200m
I.A

Hedge
P1 P2 Fund
Collateralized Debt Obligation
• Collateralized Debt Obligation (CDO)
– A structure used to distribute risk through tranching a
portfolio of credit, and issuing notes of different risk
profiles to investors.

– Riskier tranches will earn a higher investor premium,


to reflect the higher risk.

– CDO notes will typically be issued to the investor by


an SPV. 
Working of CDO

10% p.a Rights on Payment


Commercial Investment
$ 1 Billion
Bank Bank
$ 1 million
(Loan)

10% of $1B =
$100m

X 1000
CDO Contd…

10% p.a
Special Purpose Entity
Rights on
10% p.a Payments $100 m per year
Investment
$1 Billion @ end
Bank
of term

1 million
Notes
X 1000

Cash Flows:
1 Share $ 100 per year
$1000 @ term end Mortgage Backed
Security
$1.1 Billion
Investors @ $1100 per note
CDO Contd…

Borrowers ($1m x
1000)

$1 B 10% = 100k
x
1000
SPE ----------
Loans = $100m
Investor OK
Risk Averse with Risk
Investor
10% $1000 x 1m = $1B
9%

20% Default
MBS 50% Recovery
--------------------
10% of the loans are
worthless
Borrowers ($1m x
1000)
$5m
$100m 18.3% = $55m
$1 B $50m $1000

$1k x 300k
$300m Equity = $300m
7% = $21m

$300m Mezzanine $1000


$1k x 300k
= $300m
$400m Senior
6% = $24m

$1k x 400k $1000


= $400m

Mortgage Backed Collateralized Debt Obligation


IRS
• Interest Rate Swap
– An agreement to exchange interest rate cash
flows, based on a specified notional amount from
a fixed rate to a floating rate (or vice versa) or
from one floating rate to another.
Bank Quotes Lower Bank Quotes Lower
Floating & Higher Fixed Fixed & Higher Floating
Rate Rate
Company A Company B
(Utility) BANK (Cyclic)
Wants Fixed Rate Wants Floating Rate

MIBOR + 1.5% 10%


Company A Company B
(Utility) 8.5%
BANK MIBOR + 4.5% (Cyclic)

* Assume MIBOR = 6%
SWAP
A

(8%) (MIBOR + 1.5%)

B
Party Swap Swap Inflow Outflows on Total %
Outflow % % Bank Loan

A -8 (MIBOR + -(MIBOR + -8
1.5%) 1.5%)
B -(MIBOR + 8 -10% -(MIBOR + 3.5%)
1.5%)

(a) For A: (A gains 0.5%)

(b) For B: (B gains 1%)


THANK
YOU!!

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