Credit derivatives
Sponsored Links
This presentation is the property of its rightful owner.
1 / 30

Credit Derivatives PowerPoint PPT Presentation

  • Uploaded on
  • Presentation posted in: General

Credit Derivatives. Credit Derivatives. A credit derivative  financial instrument Allows participants to decouple credit risk from an asset and place it with another party. Credit Risk.

Download Presentation

Credit Derivatives

An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript

Credit Derivatives

Credit Derivatives

  • A credit derivative  financial instrument

  • Allows participants to decouple credit risk from an asset and place it with another party

Credit Risk

Credit risk is the risk of loss due to a Debtor's non-payment of a Loan or other line of Credit, either the Principal or Interest (Coupon) or both.

To reduce or strip out Credit risk, Risk Manager may :

Take Collateral

Make loss provisions

Actively manage the Credit Risk Exposure

or use Credit Derivatives : Credit Default Swaps (CDS)

Credit Risk

  • Downgrade Risk

  • - Rating agency reduces debtor’s credit rating

  • - Reduces value of debt

  • Default Risk

  • - Loan not repaid in full

  • - Future cash flows not certain

Rating Agencies

  • Risk is measured by rating agencies

  • - Moody’s

  • - S&P

  • - Fitch

  • Rating scales:

Types of Credit Derivatives

  • Credit Default Swap (almost 90% of all transactions)

  • Dynamic Credit Default Swap

  • Credit intermediation Swap

  • Basket Credit Default Swap

  • Total Rate of Return Swap

  • Credit (spread) Option

  • Downgrade Option

  • Collateralized Instrument

  • Credit-linked Note

  • Synthetic Collateralized Debt Obligation

Credit Default Swaps CDS

  • First CDS

  • introduced in 1995 by JP Morgan

  • in an attempt to free up all that capital they were obliged, by federal law, to keep in reserve in case any of their loans went ‘bad’.

  • Estimated Size of the CDS market (Q1 2008):

  • USD 65 trillion

  • Global GDP: USD 55 trillion (2007,IMF)

Characteristics of Credit Default Swaps

  • Market of CDS is divided in three sectors:

  • Corporates

  • Bank credits

  • Emerging markets sovereign

  • OTC agreement (privately negotiated transactions)

  • CDS ranges in maturity from one to ten years

  • Five year maturity is the most frequently traded

  • CDS provides protection only against previously agreed upon credit events

Credit Events

  • According to ISDA 2003 Master Agreement

  • Bankruptcy

  • (insolvency or inability to pay its debts)

  • Failure to pay

  • (principal or interest)

  • Debt Restructuring

    (change in the terms of the debt that are adverse for creditors)

  • Repayment Acceleration on Default

  • Repudiation

  • (sovereign only – indication that a debt is no longer valid)

  • One of this event has to have happened on the reference entity in order a CDS payment to be made

What is a single CDS

  • Bilateral contract

  • Protection buyer pays premium to protection seller

  • Protection seller  contingent payment upon default of reference asset

  • One party usually owns the Reference asset

  • Otherwise: transaction does not involve credit exposure  speculation on behalf of both parties

  • Premium paid is known  CDS Spread

Reference Asset

  • Bank loan

  • Corporate debt

  • Trade receivables

  • Emerging market debt

  • Convertible securities

  • Credit exposures from other derivatives

CDS Spread

  • Quoted in Basis Points per annum

  • Paid periodically

  • If corporate quarterly

  • sovereign  monthly

  • Credit Spread =Default probability x (1-recovery rate)

  • Premium = notional amount x CDS spread p.a.

Example on Premium of Bulgarian 5Y CDS

  • Notional amount = USD10,000,000

  • Spread= 494 b.p.

  • Premium = notional amount x CDS spread

  • = 10,000,000 x 0.0494

  • = 494,000 p.a.

Payoff from CDS

  • The payoff can be defined in terms of

  • Physical delivery of the reference asset

  • delivery of the Defaulted Bond for the Par value (no later than 30 days after the credit event)

  • or

  • Cash Settlement

  • pays the Protection Buyer the difference between the Par value and (real) Recovery value of the Bond (within 5 days of the credit event)

  • Settlement terms of a CDS are determined when the CDS contract is written

Buyers and sellers of protection

Cash Settlement ExamplePayoff from a Credit Default Swap

  • Bank A holds a corporate bond issued by C

  • Reference asset Bond C, maturing in two years

Cash Settlement ExamplePayoff from a Credit Default Swap

  • To reduce credit risk:

  • Bank A enters in two year CDS with Bank B, with notional amount 10 millions (protection buyer)

  • Bank B  contingent payment to A in the event of default of reference asset C (protection seller)

Cash Settlement ExamplePayoff from a Credit Default Swap

  • Bank A pays periodically the premium to Bank B

  • CDS on C is quoted 52 bps (per annum)

  • Premium= notional Amount x CDS spread

  • = 10,000,000 x 0.0052 = 52,000

Cash Settlement ExamplePayoff from a Credit Default Swap

  • After one year:

  • C defaults on the bond by declaring bankruptcy

  • Market value  falls to 48.63% of its par value

  • because

  • Market expectation is that C will only be able to pay back 48.63% of total outstanding

Cash Settlement ExamplePayoff from a Credit Default Swap

  • The payoff on default will be calculated as follow

  • Notional principal x Par Value – Market Value 100

Cash Settlement ExamplePayoff from a Credit Default Swap

  • Bank B  makes payment to Bank A

  • USD 10,000,000 x (100–48.63)/100 =USD 5,137,000

Cash Settlement ExamplePayoff from a Credit Default Swap

  • Net effect

  • CDS  allowed Bank A to insulate itself from credit risk by holding the risky bond C

  • The payoff from sale of reference asset:

  • USD 10,000,000 x 48.63 = 4,863,000

Cash Settlement ExamplePayoff from a Credit Default Swap

  • Bank A receives the recovery rate from the sale of the underlying reference asset USD 4,863,000 and payoff of USD 5,137,000 from Bank B

  • Total 10,000,000

  • Bank Bacquired the credit risk of holding the bond without actually holding it in return for receiving the premium from BankA

Use of CDS

  • Hedging

  • Protection buyer owns the underlying credit asset

  • Speculation

  • Protection buyer does not have to own the underlying asset


  • CDS  manage the credit risk

  • Protection buyer  hedge their exposure by entering into CDS contract

  • IF reference asset defaults  the proceeds from CDS will cancel out the losses on the underlying

  • Protection buyer  will have lost only the payments over that time

  • IF reference asset does not default protection buyer makes the payments reducing investments returns but eliminates the risk of loss due to reference entity defaults


  • Investor  speculates on changes in an entity’s credit quality

  • If credit worthiness declines => CDS spread will increase

  • If credit worthiness increases => CDS spread will decline

  • Example: a hedge fund believes an Entity will default soon  buys protection


  • IF reference asset defaults 

  • Protection buyer will have paid the premium but will receive from the protection seller the notional amount making a profit.

  • IF reference asset does not default 

  • CDS contract will run for whole duration without any return


  • The hedge fund could liquidate its position after a certain period of time  lock in its gains or losses

  • IF reference asset is more likely to default => CDS Spread widens

  • So, hedge fund  sells protection for the rest of CDS duration at a higher rate => makes profit (given that reference asset does not default during this time)

  • IF reference asset is much less likely to default => CDS spread tightens

  • So, hedge fund  again sells protectionfor the rest of CDS duration in order to eliminate the loss that would have occurred

  • Login