Credit default swaps market

An interesting development in the credit default swap market is the response of protection sellers to credit events, the impact is ultimately reflected in the price of credit default swaps, as reflected by the credit default swap spread. Credit derivative markets have experienced spread widening at times of bad credit related news, in effect this reflects the protection sellers pricing the risk of the additional probability of a credit event into the protection they sell. 

The pricing of credit default swaps is determined in the credit default swap market by traders who determine the credit default swap spread through their assessment of the default risk of the reference obligations. This spread information can give valuable information about the key pricing components of the reference credit implied probability of default of the reference credit and recovery assumptions. These price... 

The credit curves (or default swap curves) reflect the term structure of spreads by maturity (or tenor) in the credit default swap markets. The shape of the credit curves are influenced by the demand and supply for credit protection in the credit default swaps market and reflect the credit quality of the reference entities (both specific and systematic risk). The changing levels of credit curves provide traders and arbitragers with the opportunity to measure relative value and establish credit positions. 

If an investor s funding cost is above LIBOR, then selling protection would appear more attractive than carrying a cash position and experiencing a reduced carry on the bond returns due to the funding cost. Many players in the credit default swap markets fund above LIBOR and it would seem that selling protection may cause default swap spreads to narrow. 

A credit default swap (CDS) price provides fundamental credit risk information of a specific reference entity or asset. As explained before, asset swaps are used to transform the cash flows of a corporate bond for interest rate hedging purpose. Since the asset swaps are priced at a spread over the interbank rate, the ASW spread is the credit risk of the same one. However, market evidence shows that credit default swaps trade at a different level to asset swaps due to technical... 

The market for single-name credit default swaps has rapidly developed in volume over the past few years and represents the highest proportion of the global credit derivatives market by notional value. The credit default swap is linked to the reference entity and its obligations. 

Within the credit derivative market, a common tenor for transactions is the 5-year maturity. Credit default swaps have most liquidity at the 3-year and 5-year maturity/tenor. As a result, we often see that 5-year credit default swaps are used in structured credit transactions, such as collateralised synthetic obligations (CSOs) for this reason. Credit derivatives with a long maturity (over five years or with a short maturity (under one year) are less common. 

In Europe and Asia, the standard credit default swap contract used the restructuring definition (sometimes referred to as old restructuring ), whereas in the North American markets the standard credit default swap contracts refer to modified restructuring. The 1999 ISDA Credit Derivative Definitions would have been effective until early 2003. The 2003 ISDA Credit Derivative Definitions, which were in place in early 2003 (implementation in May 2003), have implemented some key amendments to the 1999 definitions, some of which were previously included in supplements issued by ISDA. 

This last equation shows the direct relationship between the probability of default and the market credit default swap quotes. Therefore, using equation (21.14) and the term structure of credit, we may be able to boot-strap the market implied probability of default from the credit curves, which are in effect the range of credit default swap quotes by maturity. Equation (21.14) is only approximate because in practice we would need to ensure that the timing of projected cash flows are accurately reflected in the pricing model. For example, the actual payment on the contingent leg may depend on the settlement date for the swap. 

In this way, any changes of shape and perceptions of the premium for CDS protection are reflected in the spreads observed in the market. In periods of extreme price volatility, as seen in the middle of 2002, the curves may invert to reflect the fact that the cost of protection for shorter-dated protection trades at wider levels than the longer-dated protection. This is consistent with the pricing theory for credit default swaps. 

However, it is also possible that an investor may find that there is a negative basis. For example, the credit default swap spread is less than the asset swap level for a cash instrument issued by the same reference entity. This situation may arise in the markets ... 

If standard 3- and 5-year credit default swaps are often more liquid than the cash market for similar tenors. Therefore, the liquidity premium to the cash investor in this situation would be included within the asset swap. 

Credit default swap positions may be compared to bond positions when examining relative value of between the cash markets and the derivative markets. It is most common to compare the CDS with the bond on one of the following bases ... 

In recent years, the valnation of certain synthetic instrnments, snch as credit default swaps (CDS), has become a routine task in financial markets. Meanwhile, variations on the core CDS product are emerging, and more complex instruments, such as synthetic collateralized debt obligations (CDOs), that use CDSs as building blocks for larger transactions continue to see analytic evolution. This chapter provides an introduction to the basics of pricing and explores some of the tools available to those involved in the synthetics market. 

While it is not uncommon for active market makers and end users to utilize their own, customized set of tools for credit default swap valuation, many, if not all of these methodologies arise from the same general framework and ask the same two questions What is the probability that a particular issuer will default and, Upon the occurrence of a default event, what does one expect to recover from an issuer ... 

Given the lengthy discussion devoted to valuing the credit default swap, it makes perfect sense to be able to solve backwards for X, given observable data in the market. If the default swap market is active for a particular issuer, a trader can observe the premium being paid for default protection directly in the market. With a known value for the premium P, and an assumption for R, the hazard rate X can be extracted. Since there is no initial exchange of cash when a default swap is executed, it... 

Identifying and capturing intraname relative value is one of the surest ways of beating a benchmark, as there is no additional credit risk involved. The rapid development and growth of the default swap market provides an important reference point for this exercise. 

A much easier method of generating leverage in a credit portfolio is through credit default swaps (CDS). They let investors take on or lay off default risk in an unfunded manner. Selling default protection enables one to receive the premium associated with the additional credit risk without the need to buy a bond of that entity, and in the process creates enormous leverage, especially for higher rated credits. The increased liquidity and the compression of bid/offer spreads have added to the attractiveness of this market. 

CLNs provide an excellent window to create securities bearing the maturity, currency and credit risk one would like to take on, unconstrained by the availability of the bond in the marketplace. For example, in the auto sector one of the stronger names is BMW, but the company does not have many bonds outstanding. However, the name is a very liquid in the default swap market. Therefore, for investors who want exposure to the name would find it easier to gain it by buying a CLN. 

Emerging Market) Credit Default Swaps Subordinated Tranche... 

Credit default swaps can be used to trade credit spreads. Say investors believe the credit spread between certain emerging-market government bonds and U.S. Treasuries is going to widen. The simplest way to exploit... 

An update on developments in the credit derivative market, which takes in the development of the iTraxx and CD-X indices, credit default swap trading strategies, and the 2009 big bang in the... 

The most prominent impediment to swap market liquidity is swap counterparty credit exposure, which is balance-sheet intensive, in that it is a bilateral contract. The risk is the potential loss to a counterparty of the present value of a swap position if a swap party defaults. Therefore, parties to a swap transaction must be confident in the credit quality of... 

This approach is circular and only works well in cases where liquid credit default markets already exist for an issuer. This is not always the case and was definitely not the case when default swaps were first introduced. Nonetheless, it still requires a highly subjective recovery value assumption. 

The default risk component of a swap spread will be smaller than for a comparable bond credit spread. The reasons are straightforward. First, since only net interest payments are exchanged rather than both principal and coupon interest payments, the total cash flow at risk is lower. Second, the probability of default depends jointly on the probability of the counterparty defaulting and whether or not the swap has a positive value. See John C. Hull, Introduction to Futures and Options Markets, Third Edition (Upper Saddle River, NJ Prentice Hall, 1998). 

There are several advantages of using credit derivatives apart from generating leverage. CDS enables investors to assume credit risk in the form and denomination they choose, circumventing to a large extent the constraints on cnrrency and maturity imposed by the bond market. CDS is a cleaner vehicle to take a view on credit without taking interest rate exposure when compared to a traditional asset swap. In the event of default a CDS unlike traditional asset swaps does not leave the investor with residual swap exposure. 

Another indicator of credit risk is the credit risk premium the spread between the yields on corporate bonds and those of government bonds in the same currency. This spread is the compensation required by investors for holding bonds that are not default-free. The size of the credit premium changes with the market s perception of the financial health of individual companies and sectors and of the economy in general. The variability of the premium is illustrated in FIGURES 10.2 and 10.3 on the following page, which show the spreads between the U.S.-dollar-swap and Treasury yield curves in, respectively, February 2001 and February 2004. 

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