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CREDIT DERIVATIVES

&
STRUCTURED PRODUCTS

FRM(Term V) 2013
Dr. Kulbir Singh
IMT-Nagpur
Market: Credit Derivatives & CDS

Source: BIS Quarterly Review, December 2013

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Credit Derivatives Participants

Net Net
Buyers Sellers

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Credit Derivatives - Positive/Negative Consequences
• CD are designed to transfer credit risk on pf of bank
loans/debt securities – facilitating the transfer of credit
risk from banks to non-banks, principally insurance co.s
• This development has both +ve/-ve consequences:
• +ve:
– Banks hold more diversified pf, use of CDS reduces
vulnerability to systemic shocks…. Credit is more available,
likely hood of credit crunch reduced when lenders can use
Credit der.
• -ve:
– Can produce wedge between borrowers and lenders
– Dispersing credit risk throughout the financial system ,
shocks of systemic can be broadly felt.
– Eg. Credit Crisis of 2007-09

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Credit Derivatives - Positive/Negative Consequences
• Paradox Credit:
– To reach the efficient
frontier and/or improve its
risk-return performance -
trade loans
– Not possible --- Spoil r/b
with borrowers
• Alternative way
– Off-Balance Sheet – Credit
Derivatives
– For Cust. R/b, tax, liquidity,
trans. Cost – prefer CD as
soln. for loan pf
optimization

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CDS Mechanism

2009 2010 2011 2012 2013 2014

Mar 01 Mar 01 Mar 01 Mar 01 Mar 01 Mar 01


$900,000 $900,000 $900,000 $900,000 $900,000

Credit
Premium/
Spreads

• Expressed in bps
• Market Maker (bankers) quote Credit spread in bid-offer basis point
• Eg. Bid - 250bps [2.5% of principal/yr] and Offer - 260 bps [2.6% of principal/yr]
• Most popular – payments made quarterly and in arrears

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CDS Mechanism

Credit
Event
2009 2010 2011 2012 2013 2014

June 01
Mar 01 Mar 01 Mar 01 Mar 01 Mar 01 Mar 01
$900,000 $900,000 $900,000 $900,000 $900,000

$225,000

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CDS and Bond Yields
• Effect of CDS to convert the corporate bond to a risk-
free bond (at least approx.)
• n-year CDS spread = n-year (YCB – YRfB)
• If CDS spread > (YCB – YRfB)
– Borrow at Rf Bond by shorting Corporate Bond & selling
protection, & make a profit
• If CDS spread < (YCB – YRfB)
– Buy Corporate Bond & buy protection, & earn more than
Rf bond.
• Close to perfect arbitrage & good guide to r/b CDS
spread and bond yields
• CDS spread can be used to imply Rf rates by market
participants.

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Physical Delivery: Cheapest-to-Deliver Bond
• CDS specifies that a number of different bonds
can be delivered in event of default
• At default, buyer/calculation agent review
alternative bonds and chose for delivery the
one that can be purchased most cheaply.

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Counterparty Risk
• Protection will be effective with low correlation b/w default risk of the u/l credit and
of counterparty.
• Credit derivatives can be
• Unfunded
– Each party is responsible for making payments (i.e., premiums and settlement amount) w/o
recourse to other assets.
• Funded
– The protection seller makes a payment that could be used to settle any potential credit event.
– protection buyer is not exposed to counterparty risk.

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Credit Derivatives Types
• Single Name
– CDS …most popular
– Total Return Swap (TROR)
• Multi Name
– CDO

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Credit Default Swap (CDS)

Source:http://www.youtube.com/watch?v=cmUXTFggIa0
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Credit Default Swap (CDS)

Source:http://www.youtube.com/watch?v=cmUXTFggIa0
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CDS Numerical: HW
• Chapter 23, Jorion
– Example 23.3, 23.4, & 23.6
• Extra Numerical (will be used for testing skills
in exam)
– Numerical Set: Credit Derivatives …Handout
distributed in the class

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Total Return Swap

Source:http://www.youtube.com/watch?v=cmUXTFggIa0
15
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Valuation of Credit Default Swaps (CDS)
• Mid-Market CDS spreads (av. of bid & offer CDS spread) can be calculated
fro default probability estimates
• Suppose the PD of ref. entity defaulting a year conditional on no earlier
default is 2%.
• Table below shows survival probabilities and unconditional PD (i.e. PD as
seen at time zero) for each of 5 years.

Table #1

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Valuation of Credit Default Swaps (CDS)….
• Assume defaults happen halfway through a year and CDS premium paid once
at end of year.
• Rf = 5% (LIBOR) p.a. continuous compounding
• Recovery rate is 40%
• CDS premium s, & Notional Principal is $1

Table #2

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Valuation of Credit Default Swaps (CDS)….
• PV of Expected Payoff from CDS Seller in case of default by the reference
entity
• Recovery Rate is 40%, 60% will be paid by CDS seller
• Yr n: PD during Yr. x LGD x Notional Principal ($1)

Table #3

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Valuation of Credit Default Swaps (CDS)….
• PV of Expected Accrual Payments
• In case default takes place in any mid-year, then accrual payment for the
year till that period has to be paid, after receiving LGD from the seller.
• Remaining CDS premiums will be stopped.
• When this will happen, only PD will tell. Thus,…..

Table #4

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Basket Credit Swap
• Youtube
– http://www.youtube.com/watch?v=bGEQ_oafey
M

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Structured products: Multi Name CDS
• CLN
– http://www.youtube.com/watch?v=mxNMEtchKd
8
– ..\Videos\CLN
• CDO
– http://www.youtube.com/watch?v=WMwAyDnKjy
k

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