Yorkshire Actuarial Society

Credit Default Swaps

Feifei Zhang

York

9 November 2011

Credit Default Swaps: a primer

Introduction

o A CDS is an over-the-counter (OTC) swap contract in which the protection buyer makes a series of payments to the protection seller, and, in exchange, receives a payoff if a credit instrument (typically a loan or a bond) suffers a “credit event”

o A CDS is a bilateral contract which:

1. refers to a debt instrument of a “reference entity”, i.e. a corporation or a government

2. the protection buyer makes quarterly premiums

3. upon a “credit even”, the protection seller pays the buyer the par value of the bonds in exchange for “physical” delivery, although “cash” or “auction” settlements become more common

o Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (“ISDA”)

o They are not traded on an exchange (for now) but all are confirmed in the DTCC Trade Information Warehouse and are subject to regulatory trade reporting requirements

Hedging or Betting

o A bondholder can buy CDS protection to hedge its risk of default

o In this way a CDS is similar to credit insurance but not quite…:

1. buyer doesn’t need to “own” any debt of the reference entity – “naked CDS”

2. buyer doesn’t need to “suffer” a credit event – synthetic long/short

3. buyer doesn’t need to deliver a “specific” instrument – cheapest to deliver

4. CDS is marked to market – collateral calls

o Key factors to consider in a CDS transaction

1. spread

2. notional

3. maturity

4. credit event

5. reference entity

6. settlement

Spread

o Equivalent to the premium of a put option on a bond: CDS buyer protected from losses incurred by a decline in the value of the bond as a result of a credit event

o Quoted in basis points (1/100th of %) per annum, usually paid quarterly on IMM dates

o NOT to be confused with “credit spread”, which refers to the spread of bond yield over the benchmark (government bond or swap)

o What determines the spread? The Market

o CDS is executes at the premium level:

Say an Aviva 5-year CDS spread is 180bps reference to the premium of 100bps

CDS buyer pays 100bps per annum quarterly

CDS buyer pays present value of 80bps through upfront payment

o If the credit event happens between two payment dates, the accrued spread is still due from the buyer to the seller – this is different from the bond investment: “accrual basis”

Notional and Maturity

o No limits on the size or maturity

o Most CDSs fall between €10-20mn

o Most CDSs fall between 1-10 years, with the 5-year most liquid

o Most common currencies are € or $, although others are possible at a premium

Credit Event

o A “credit event” triggers the CDS protection payment:

1. Bankruptcy:

2. Failure to pay: either principal or interest, after a grace period

3. Restructuring: reduction and renegotiation of delinquent debts in order to improve or restore liquidity. However in 2009, US contracts eliminated this as a potential credit event

4. Repudiation/Moratorium: related to sovereign (e.g. delay in payment)

Reference Entity

o A corporation or sovereign that generally has debt outstanding

o Reference obligation: usually an unsubordinated debt or a sovereign debt

o Deliverable obligation characteristics, generally speaking:

1. A bond or a loan

2. Maximum maturity of 30 years

3. Not subordinated

4. Not subject to transfer restrictions

5. Standard currency

6. Not subject to contingency before expiry

Physical Settlement

o The seller pays the buyer par value, in exchange of debt obligation of the reference entity

o Outstanding CDS notional much larger than the outstanding debts

o Example: Lehman Brothers default 14 September 2008

1. $155bn outstanding debts

2. $400bn outstanding CDSs!

Cash Settlement

o The seller pays the difference between par value and the market price of a debt obligation of the reference entity

o An auction (credit-fixing event) will be held to facilitate cash settlement

o Participating dealers submit prices at which they are willing to buy and sell, as well as net requests for physical settlement against par

o A second stage Dutch auction is held following the publication of the initial mid-price of the dealer market and what is the net open interest to deliver or be delivered actual debts

o Final clearing price set for all CDSs and all physical settlements requests as well as matched limit offers resulting from the auction are actually settled

o Auction processes are organized and conducted by ISDA

CDS Auction SettlementDate Reference Entity Final Price (% par)

Oct. 05 Delta Airlines 18Oct. 08 Fannie Mae - snr 91.51Oct. 08 Freddie Mac - snr 94Oct. 08 Lehman Bros 8.625Oct. 08 WaMu 57Nov. 08 Landsbanki – snr

Landsbanki – sub1.25

0.125Jan. 09 Republic of Ecuador 31.375June 09 GM 12.5Nov. 09 CIT 68.125Jan. 10 FGIC 26June 10 AMBAC 20June 11 AIB – snr

AIB – sub70.12510.375

Basis Trade (1)

o In theory, holding bond + CDS of the same maturity is default risk free

o Instead of buying bonds, some investors do hold a risk-free bond and write a CDS to create a “synthetic” credit exposure

o Basis = CDS spread (premium) – bond credit spread (Z-spread)

o Positive basis: bond spread < CDS spread

o Negative basis: bond spread > CDS spread

o Why basis exists at all?

1. Currency

2. Maturity

3. Seniority

4. Accrued interest

5. Settlement (delivery)

Basis Trade (2)

o Why positive basis

1. Seen as “norm” as CDS spread contains an “insurance premium”

2. Difficulties in shorting corporate bonds over a long period

o Why negative basis

1. Seen as “anomaly” and hence more negative basis trading

2. “Hair-cut” in CDS premium due to counterparty risk

3. Writing CDS requires less cash than direct purchase of bonds

o Negative basis as a proxy of illiquidity premium

Negative Basis

-100

-50

0

50

100

150

200

250

300

Eur Neg Basis

GBP Covered Bonds

QIS5 proxy

source: RBS based on iTraxx Main – iBoxx Eur Corp

-400

-300

-200

-100

0

100

200

14-Jan-2004 28-May-2005 10-Oct-2006 22-Feb-2008 06-Jul-2009 18-Nov-2010 01-Apr-2012

iTraxx - iBoxx $ Spread 3M EURIBOR-OIS Spread Basis as % Corp Spread

UK Risk’s own analysis on iTraxx Main – iBoxx 5-7 year Eur Corp

Risks

o Market risk

1. Mark-to-market of CDS prices due to daily fluctuation of CDS spreads

2. Interest rate risk

o Counterparty risk

1. Double default of reference entity and CDS writer

2. Replacement risk

o Liquidity risk: margin call on collateral, e.g. AIG

o Settlement risk: defaulted bond holding after cash settlement, e.g. Delphi

o Basis risk: see previous slides

o Legal risk: different definitions of “credit event” under different jurisdictions, e.g. AON

CDS Products

o Single-name CDS: traditional and most common, OTC

o Index CDS

1. Credit risk hedge on a basket of credit entities

2. Completely standardized, more liquid, and tighter bid-offer spread

o Tranched index CDS

1. Reference to a specific segment of the index’s loss distribution

2. Tranche: portfolio losses that fall into a medium range (e.g. 3%-7% losses)

3. Attachment (e.g. 3%): below which losses borne by more junior tranches

4. Detachment (e.g. 7%) above which losses borne by more senior tranches

CDS Indices

o CDX index (North America) and iTraxx index (Europe) – published by markit, rolled every 6 months

o CDX: Most liquid baskets of names in NA

1. IG or investment grade (125 names)

2. High yield (100 names)

3. Crossovers, i.e. between IG and junk (35 names)

4. Emerging Markets (14 names)

o iTraxx: Most liquid baskets of names in Europe (Asia)

1. 3,5,7,10-year

2. Main (125 names)

3. HiVol (30 non-financial names)

4. Crossovers

5. Financial (25 names) – SEN and SUB

iTraxx Series 16

o Rolled on 20 September 2011

o Financial 25 in Series 14

Aegon, Allianz, Generali, Aviva, AXA,

Banca MDP, BBVA, BES, Santander, HBOS

Barclays, BNP, Commerzbank, Credit Agricole, Credit Suisse

Deutsche Bank, Hannover Re, ISP, Munich Re, SocGen

Swiss Re, RBS, UBS, Unicredit, Zurich

o Financial 25 in Series 15: LTSB replaced HBOS

CDS Standardization

o Big Bang Protocol (April 2009)

1. Credit event determination by regional committees

2. Credit event eligibility period (-60 days ~ +90 days)

3. Legalization of cash auction process in the CDS contract

o Small Bang Protocol (July 2009)

1. Restructuring

2. Cash auction if protection buyer calls for trigger payment

3. Maturity bucketing (0-2.5y, around 5y, 7.5y, 10y)

o Dodd-Frank Act (July 2010)

1. Distinction between “swap dealer”, “commercial end-users” & “major swap participant”

2. “Push-out” swap dealers and MSPs from receiving Federal assistance if they conduct non-permissible swaps including non-investment grade entity CDSs and uncleared CDSs, within a depositary banking institute

CDS Valuation

o Pricing: effectively similar to life term assurance pricing

o Market risk measure:

Risky PV01 (duration): change in value of the CDS for a 1bps shift in the credit curve

1. Measure of both the spread risk and the interest risk

2. Misleading if volatile spread movement

o Default risk measure: for the CDS seller

Value-on-default (VoD): change in value of the CDS due to an overnight default

1. Cash outgo of auction settlement; plus or minus

2. Market value of CDS before default

Default Fee leg Contingent leg Default densityDeath PV premium PV benefit Force of mortality

Credit derivatives

Case Study: DB vs. Aviva!

o In 2009, a hedge fund approached Deutsche Bank Primary Brokerage for a 5-year € amortizing loan, bearing Libor + x% interest, to be repaid 20% capital every anniversary

o The loan is fully collateralized with 5 €-denominated Aviva With-profits bonds maturing in the next 5 years, and with guaranteed maturity value = 20% loan

o The WP bonds are issued by Aviva Ireland , reinsured by Aviva UKLAP (AA- rated)

o The loan was not approved by DB Risk in the first instance as DB already had too much open exposure to Aviva

o The PB proposed a risk mitigation plan by saying that it will buy some 5-year CDSs with Aviva Plc (A+ rated) as the reference entity – Aviva Plc is the only legal entity in the Aviva group whose CDSs are publicly traded with sufficient liquidity

o Aviva CDS was traded y% then, with y < x

o As a risk manager, are you comfortable with the risk mitigation plan and why?