Credit default swaps
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Credit Default Swaps. Shane Kaiser. Credit Default Swaps. A credit default swap (“CDS”) is an over-the-counter credit derivative contract between two counterparties that was originally implemented to transfer credit-risk

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Credit Default Swaps

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Credit Default Swaps

Shane Kaiser


Credit Default Swaps

  • A credit default swap (“CDS”) is an over-the-counter credit derivative contract between two counterparties that was originally implemented to transfer credit-risk

  • The risk of default is transferred from the holder of the debt security to the seller of the swap.

  • Originally used by big banks as insurance against loans exposure, but has since grown to be used for things like making a profit on speculation


Credit Default Swaps

  • Two parties: protection buyer and protection seller

  • The “protection buyer” purchases a CDS from the “protection seller” by making periodic payments (typically either semiannually or quarterly), called a CDS premium, to the “protection seller”, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event.

  • Protection buyers typically buy $10 million in protection with a maturity period of 5 years.


History

Source: International Swaps and Derivatives Association (“ISDA”)


Types of Credit Default Swaps


Single Name Default Swap

  • The simplest and most common type of CDS

  • Only one reference entitythat can be any borrower, but is usually one of a few hundred widely traded companies

  • Commonly used by big banks to free up capital

  • Currently used by many hedge funds, because not much capital is required to purchase a swap


Portfolio Default Swaps

  • Nearly the same as Single Name Default Swaps, but reference around 50 to 100 (or more) underlying entities

  • Mostly all Portfolio Default Swaps have been replaced by index default swaps


Index Default Swaps

  • Unlike a regular credit default swap, an index default swap (or CDX) is a completely standardized credit security, there for Index Default Swaps can be more liquid and trade at a smaller bid-ask spread

  • Makes it cheaper to hedge a portfolio with a CDX than it would be to buy many single CDS


Pricing/Payout


Pricing

  • Every underlying is give a certain amount of “basis points” (each representing .01%)

  • These basis points are dependent upon the stability/riskiness of the underlying credit

  • The riskier the underlying, the higher the basis points will be.

    • Reflect markets perception of the risk of default over the risk free rate, almost like a percentage chance of how likely the underlying will default before maturity


Pricing - Example

  • A CDS spread for Corporation A is 40 basis points

  • Thus a protection buyer buying $10 million in protection must pay the protection seller $40,000 annually ($10 million * 0.4%) till maturity or a credit default of the underlying occurs.

  • Payments are typically made semiannually with a maturity of 5 years, thus in this case the buyer will be paying the seller $20,000 each quarter for the next 5 years (assuming no credit event occurs)

  • The buyer would have lost $200,000 in this event


Payout

  • In the event of a credit event (eg, bankruptcy):

    • The protection buyer no longer needs to pay the seller (in this example it was $20,000 every six months)

    • The two parties wait 30 days after the credit event, and seewhere the senior debt of the underlying is trading on that 30th day

    • After those 30 days, the protection seller pays back the protection buyer the amount of protection purchased times, one minus the current price of the debt is trading


Payout -Example

  • If the protection buyer purchased $10 million in protection, and the underlying defaults, the payout seller waits 30 days after the default occurs to determine how much to pay the protected buyer.

  • If the senior debt is trading at $0.30 cents on the dollar on that 30th day then the pay out will be:

    • $10 million * (1 - $0.30) = $7 million dollar payout


Profitability

  • If the underlying goes into default, the protection buyer stops paying the seller that quarterly amount immediately, and receives payment in 30 days.

  • This can create extremely profitable situations

  • For example:

    • A protection buyer purchases $10 million in protection on an entity with 300 basis points (fairly risky company) and a maturity of 5 years

    • The underlying defaults in 12 months and the senior debt drops to $0.50 cents on the dollar

    • ($ 10 million * (1 - $0.50)) – ($10 million * 3%) = $4.7 million


Criticism/Controversy


Criticism/Controversy

  • “Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster.”

    -Matthew Philips, MSNBC-Newsweek


Criticism/Controversy

  • Famous Cases in 2008:

    • AIG - defaulted on $14 billion worth of credit default swaps made with various investment banks, insurance companies and other entities, and needed the American government to bail them out

    • Bankruptcy of Lehman Brothers - due to subprime mortgage crisis Lehman Brothers declared bankruptcy, and caused nearly $400 billion to become payable to the buyers of CDS in Lehman Brothers


Criticism/Controversy

  • Original intent:

    • to spread risk and act as insurance on loan exposure

  • Unintended side affects:

    • Created more risk, with very little leverage and no regulation

    • Created more negative speculation

    • Became more of a money making scheme than a device to protect and hedge


Sources

  • http://www.newsweek.com/2008/09/26/the-monster-that-ate-wall-street.html

  • http://en.wikipedia.org/wiki/Credit_default_swap

  • http://www.investopedia.com/terms/c/creditdefaultswap.asp

  • http://www.isda.org/

  • http://money.cnn.com/2009/03/16/markets/cds.bear.fortune/index.htm

  • http://www.ft.com/cms/s/0/25137702-972d-11dd-8cc4-000077b07658.html#axzz14sX36S7Q


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