Default Swap

The credit default swap basis and trading issues 6 Bibliography 11... 

THE CREDIT DEFAULT SWAP BASIS AND TRADING ISSUES... 

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... 

Choudhry, M., 2006. The Credit Default Swap Basis. Bloomberg Press, New York. 

Truck, S., Laub, M., Rachev, S.T., 2004 The terms structure of credit spreads and credit default swaps - an empirical investigation. Working Paper, September. 

EXHIBIT 12.2 Typical Synthetic Stracture with a Credit Default Swap... 

Although the products typically identify with structured credit seem extensive and often confusing, reflecting the numerous underlyings that are possible bonds, loans, credit default swaps, and so on versus CBOs, CLOs, CSOs, and so on. They all achieve a very similar value proposition they are vehicles to pool and redistribute risk. In many ways, all these products are best classified as derivative instruments given that they... 

Credit derivative products are defined by reference to underlying reference entities, and reference obligations, which include corporate bonds, bank loans, sovereign debt, Brady bonds, and Eurobonds. Credit derivatives are now used increasingly in structured transactions. For example synthetic collateralised loan obligations (see Chapter 15) often use credit default swaps to transfer credit risk from the originator to the special purpose vehicle (SPV). Currently, the most common products are credit default products and total return swaps. 

Credit default swaps involve the exchange of periodic payments (usually expressed as basis points multiplied by the notional amount of the swap)... 

The cash flows of a typical credit default swap are set out in Exhibit 21.1. Exhibit 21.2 shows the Bloomberg screen CDS for credit default swap prices. 

EXHIBIT 21.2 Credit Default Swap Bloomberg Price Screen... 

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. 

Credit default swaps are triggered by the occurrence of credit events. If a counterparty provides a Credit Event Notice than this indicates that a credit event has occurred, this is usually accompanied by Public Available Information. 

The most common form of settlement chosen is physical settlement, in this situation the buyer of protection will deliver the defaulted asset or other assets that are pari passu with the reference obligation—effectively the asset delivered is covered by the credit default swap contract—to the seller of protection for par value (in cash). 

Cash settlement represents another method of settling credit derivative transactions. In cash settlement, the protection buyer will receive an amount based on the difference between par and the valuation of the reference asset at a given valuation date, as agreed in the credit default swap contract. 

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. 

Since credit default swaps are written on the reference entities, their pricing provide information on the default probabilities of the issuer and are not subject to liquidity premia that can be present in the credit spreads of the credit risky bonds. Therefore, the term structure of credit default swap spreads for a particular issuer is used to determine the cumulative default probability of the issuer. 

Another adaptation of the credit default swap is the digital CDS in which a defined cash flow on the contingent leg takes place when a credit event occurs. 

More complex default swap products can also be structured, for example, a first to default basket swap. In this product the buyer makes periodic payments for a contingent default payment on the first default of a group of securities. A diagrammatic representation is shown at Exhibit 21.3. 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

For example, if we have a CLN that pays out a reduced amount on the event of default of a reference asset, then this CLN may be similar to a straight forward cash investment plus the sale of a credit default swap (CDS). 

The 1999 ISDA Credit Derivatives Definitions listed six credit events that could be incorporated into credit default swaps. These are... 

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. 

Some practitioners argue that Merton models are more appropriate than reduced form models when pricing default swaps on high-yield bonds, due to the higher correlation of high-yield bonds with the underlying equity of the issuer firm. 

The JLT model allows the pricing of default swaps, as the risk neutral transition matrix can be used to determine the probability of... 

Various credit derivatives may be priced using this model for example, credit default swaps, total return swaps, and credit spread options. The pricing of these products requires the generation of the appropriate credit dependent cash flows at each node on a lattice of possible outcomes. The fair value may be determined by discounting the probability-weighted cash flows. The probability of the outcomes would be determined by reference to the risk neutral transition matrix. 

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... 

A credit default swap has two valuation legs, the fee leg and the contingent leg. We can develop an equation of value which describes the valuation of the credit default swap (assuming a deterministic recovery rate) as... 

Using these discrete results we could express the credit default swap spread as follows ... 

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. 

Recovery rates on bonds vary by the position in the reference entity s capital structure and the level of security offered to the bond holders. Determining the appropriate recovery rate is not a trivial process and requires careful analysis into the traded prices of deliverable obligations for the reference credit. In practice there is limited historical information on the recovery rates experienced for credit default swaps. 

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. 

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