Protection seller

CDS premiums are above zero As we know the CDS price represents a premium paid by the protection buyer to the protection seller. The protection seller, or the bank, will expect a premium, that is a positive CDS basis over the interbank curve ... 

Default protection The CDS size will be affected on the default event. Protection seller considers this risk on the CDS premium, increasing the basis ... 

Bonds trading above or below par Bonds that trade away from the par will affect the basis. In our example both bonds trade at premium, so, decreasing the loss in the case of default suffered by the protection seller in respect to one of the cash bondholder. This pushes down the basis. 

Credit derivative transactions involve both a protection buyer and protection seller. Banks currently act as either buyers or sellers of credit protection in a transaction. Insurance companies are also active in the credit derivatives market as sellers of credit protection. 

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. 

In some versions of a TRS the actual underlying asset is actually sold to the counterparty, with a corresponding swap transaction agreed alongside in this type of TRS, the protection seller will make an upfront payment for the market value of the reference asset to the protection buyer. Yet another variation involves no change in physical ownership but still involves an upfront payment of the market value of the reference asset an example of this kind of TRS is described in Exhibit 21.4. On occurrence of a credit event the TRS will be terminated using physical settlement, so that the reference asset is delivered to the protection seller. 

Exhibit 21.4 illustrates a generic TR swap. The protection buyer has contracted to pay the total return on a specified reference asset, while simultaneously receiving a LIBOR-based return from the protection seller. The reference or underlying asset can be a bank loan such as a corporate loan or a sovereign or corporate bond. The total return payments include the interest payments on the underlying loan as well as any appreciation in the market value of the asset. The protection seller will pay the LIBOR-based return it will also pay any difference if there is a depreciation in the price of the asset. The economic effect is as if this entity owned the underlying asset, as such TR swaps are synthetic loans or securities. 

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. 

In the situation where the risk of a technical default risk is higher for credit default swaps than cash bonds. This results in protection sellers demanding a higher premium. For example, default swaps may be triggered by events that do not constitute a full default on the corresponding cash asset. 

In a credit default swap, the protection buyer is effectively long a delivery option. This delivery option gives the protection buyer the opportunity to deliver the cheapest to deliver asset to the protection seller. 

Gup and Brooks (1993) noted that swaps credit risk, unlike their interest rate risk, could not be hedged. That was true in 1993. The situation changed quickly, however, in years following. By 1996 a liquid market existed in instruments designed for just such hedging. Credit derivatives are, in essence, insurance policies against a deterioration in the credit quality of borrowers. The simplest ones even require regular premiums, paid by the protection buyer to the protection seller, and make payouts should a specified credit event occur. 

The most common credit derivative, and possibly the simplest, is the credit default swap—also known as the credit or default swap. As diagrammed in FIGURE 10.4, it is a bilateral contract in which a protection seller, or guarantor, in return for a periodic fixed fee or a onetime premium agrees to pay the beneficiary counterparty in case any of a list of specified credit events occurs. The fee is usually quoted as a percentage of the nominal value of the reference asset or basket of assets. The swap term does not have to... 

Credit-linked notes, or CLNs, are known as funded credit derivatives, because the protection seller pays the entire notional value of the contract up front. In contrast, credit default swaps pay only in case of default and are therefore referred to as unfunded. CLNs are often used by borrowers to hedge against credit risk and by investors to enhance their holdings yields. 

If a credit event occurs, how much is the protection seller likely to pay This revolves around an assumed recovery rate. 

Because this is different from the fixed premium, an up-ffont payment is made between the protection seller and protection buyer, which is the difference between the present values of the fixed premium and the current market premium. 

So for example, on June 21, 2006 the market price of the June 2011 iTraxx Europe was 34 basis points. An investor selling protection on this contract would receive 40 basis points quarterly in arrears for the five years from June 2006 to June 2011. The difference is made up front the investor receives 40 basis points although the market level at time of trade is 34 basis points. The protection seller therefore pays a one-off payment of the difference between the two values, discounted. The present value of the contract is calculated assuming a flat spread curve and a 40 percent recovery rare. We can use Bloomberg screen CDSW to work this out, and FIGURE 10.23... 

From Figure 10.23 we see that the one-off payment for this deal is EUR 27,280. The protection seller, who will receive 40 basis points quarterly in arrears for the life of the deal, pays this amount at trade inception to the protection buyer. ... 

The one-off payment reflects the difference between the prevailing market rate and the fixed rate. If the market rate was above 40 basis points at the time of this trade, the protection buyer would pay the protection seller the one-off payment reflecting this difference. 

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