Credit Derivatives2003 Notional value $2.31 trillionInvestment grade bonds - $3.1 trillion

PurposesTransfer and repackaging of credit risk

Default baskets and synthetic loss tranchesNew exposure to credit risk to leverage credit risk

Credit Derivatives Market$2.306 trillion notional value in 2003 was a 50% increase from 2002Credit default swaps - 73%Correlation products Synthetic loss tranches and default baskets 22%U.S companies 43.8%European 40.1%U.S. has a much larger cash market

Banks 50%Hedging and diversificationInsurance companies 14%Hedge funds 13%

Credit Default SwapsBilateral contract to transfer credit risk of a reference entity from one party (protection buyer) to another party (protection seller)Protection buyer shorting credit riskProtection buyer makes regular payments (usually quarterly) know as the premium leg until credit event or maturity

Default swap mechanicsIf a default occurs, there is a cash settlement or physical settlement

Pari PassuFrom Wikipedia, the free encyclopediapari passu is a Latin phrase that means "at the same pace", and by extension also "fairly", "without partiality".In finance this term refers to two or more loans, bonds or series of preferred stock having equal rights of payment, i.e., have the same level of seniority. In asset management firms, the term denotes an equal allotment of trades to strategically identical funds or managed accounts.This term is also often used in bankruptcy proceedings where creditors are said to be paid 'pari passu', or each creditor is paid pro rata in accordance with the amount of his claim. Here its meaning is 'equally and without preference'.

Physical settlement most commonRequires protection buyer deliver notional amount to the seller for notional amount paid in cash. Generally, the deliverable instrument is a basket with restrictions on maturity and pari passu. The buyer is long a cheapest-to-deliver option.

Cash settlement not generally used in CDS, but is common in default baskets and synthetic CDOs

CDS MaturityMaturity tends to be one of 4 roll dates20th of March, June, September, and DecemberNew contract 5-year contract on April 12th 2004 will mature June 20th 2009Assume contract has a spread of 160 bpConvention is Actual/360Default occurs on August 18, 2005

$10 million notional valueAssume contract has a spread of 160 bpConvention is Actual/360Default occurs on August 18, 2005Cash price of deliverable asset = $34

CDS Cash Flow

Uses of CDSEasy to short credit risk. Allows hedging of credit risk or for those with a bearish credit view.CDS are unfunded so leverage is possible.CDS are customizable in terms of maturity, seniority, and currency. Deviation from market standard may incur a liquidity cost.

CDS can be used to take a spread view on credit. A CDS can be unwound to realize gains (or losses) owing to changes in credit spread,Liquidity can be better than the cash market. Most liquid is 5-year. 3-year, 7-year, and 10-year are less liquid.

International Swaps and Derivatives Association (ISDA) has a master agreement. Reduces legal risk, speeds up confirmation, and therefore enhances liquidity.

However, CDS market is not standardized. U.S, European, and Asian markets are segmented.

ISDA Credit EventsBankruptcy corporation becomes insolvent.Failure to pay reference entity does not make due payments, taking into account a grace period to avoid administrative error.Restructuring changes in the debt obligations of the reference creditor but excluding those that are not associated with credit deterioration, such as the renegotiation of more favorable crdit terms.

Obligation acceleration/obligation default Obligations become due and payable earlier than they would have been due to default or similar condition.Repudiation/Moratorium A reference entity or government rejects or challenges the validity of the obligations.

Restructuring ClauseFollowing bankruptcy, pari passu assets should have the same recovery value. After a restructuring Short term may have higher value than long-term High coupon bonds may be more valuable than low coupon bondsLoans are more valuable than bonds due to covenants

This makes a CDS valuableConsider a protection buyer with a hedge on short-term debt trading at $80 while long-term debt trades at $65. Buy the CDS, buy the long-term bond, and make delivery. An immediate $15 profit (at the expense of the protection seller).2000 Restructuring of Conseco

Old restructuring

Original standard for which delivery is a bond with a maximum maturity of 30 years

Modified Restructuring (Mod-re)Current standard in U.S. Roughly speaking, it limits the maturity of the deliverable to the maturity of the CDS contract plus 30 months.

Modified-Modified-Restructuring (mod-mod-re)Current European standard. it limits the maturity of the deliverable to the maturity of the CDS contract plus 60 months. It also allows the delivery of conditionally transferable obligations rather than only fully transferable obligations.

No restructuringEliminates restructuring as a credit event.

Restructuring and SpreadContracts may be available with all four restructuring options.No-re will have tightest spread.Mod-re spread.Mod-mod-re more valuable than mod-re and will have next widest spread.Old-re should have widest spread

CDS FormatsSwap format (unfunded format)No initial paymentCounterparty riskCredit-linked note (funded format)Buyer has to buy fund the purchase of a high credit quality bondAt maturity, the bond is returned to the buyer

Determining the CDS SpreadBefore credit event

Before credit eventOn the annual payment dates, hedged investor receives

+F D B

At maturity, buyer receives par from asset and repays borrowed amount

Determining the CDS SpreadAfter credit event

After credit eventBuyer delivers the defaulted asst to seller in return for par and repays the funding loan with this principal (assume at par)

Strategy has no initial cost and is flat following credit event, so CF before event have to equal zero

No arbitrage conditionD = F B

Par floater = LIBOR + 25bpFunding = LIBOR + 5bpF = 25bpB = 5bpD = 25bp 5bp = 20bp

Not exactIgnores accrued interest and coupon recoveryAlso lacks adjustments for availability of cash, liquidity, supply and demand, and counterparty risk

Good starting point, and if incorrect by a lot, arbitrage may exist

Default Swap BasisCDS unfunded proxy for cash bondDivergence between CDS and cash bonds is default swap basisDefault swap basis = CDS spread cash LIBOR spreadPositive basis cash bond spread inside CDS spreadNegative basis CDS spread inside cash LIBOR spread

Divergence between cash and CDS spreadFundamental factorsMarket factors

Fundamental Factors1) FundingIf buyer borrows cash to purchase a bond, and their credit quality is high, they may be able to issue below LIBOR. This means it may be better to buy bond than sell protection in CDS. If funding cost is above LIBOR, the reverse may be true.

2) The delivery optionThe cheapest to deliver option may be valuable, so long position in CDS is more valuable than short position. Widens CDS spread and increases basis.

3) CDS protects parBonds can trade above or below par because of interest rates. Bonds with high (low) coupons exposes the to a greater (lower) credit risk. Bonds below par value should pay a lower spread than the CDS, bonds above par should pay a higher spread than default swaps.

4) Counterparty riskProtection buyers will pay a lower spread because of counterparty risk. Posting collateral can reduce this risk.

Market Factors1) Technical shortHedging of synthetic loss tranches requires a significant amount of dealer hedging, reducing the basis.

2) Convertible issuanceConvertible equity funds use CDS to hedge credit risk in convertibles. This drives default swap spreads higher since there are few outstanding convertible bonds. Widening is usually not sustained and reverts to normalized levels.

3) Demand for protectionNegative view on credit can be traded in two ways - Bond can be sold short or CDS can be purchased. This can widen both cash and default swap spread. However, it is easier to do a CDS, so the widening of the spread is first observed in the CDS market.

On October 22, 2001, Enrons stock price dropped 20% to $20.65 per share, and five-year credit default swap (CDS) spreads jumped 20% to 48 basis points, after the Securities & Exchange Commission announced it was looking into the firms accounting practices. When Enron announced it had overstated profits by nearly $600m over five years on November 8, the stock was at $8.41 and CDS spreads were at 133bp. By the time Moodys and S&P finally downgraded Enron to junk status on November 28, its stock was worth little more than a dollar per share. Bankruptcy was filed on December 2, 2001.

The moral of the story, dont ignore the market, was a hard lesson for the rating agencies to learn. Five years on, one agency, Moodys, has something to show for it.

Moodys, the oldest rating agency, and alongside Standard & Poors one of the two largest agencies by market share, has developed a set of ratings indicators derived from market signals. These may be used as a counterpart to Moodys normal ratings, which are based on analysts views of an issuers creditworthiness.

The indicators, dubbed market implied ratings (MIR), highlight discrepancies between an issuers credit rating in essence, the rating agencys assessment of a companys financial situation and future outlook and the markets view of that issuer which is in effect the sum total of the expression of all bond, credit derivatives and equity investors views on that company.

It might seem like something of a no-brainer that securities the market takes a dim view of are more likely to default; but what is surprising is the degree to which it is true. Using a data set of 2,900 issuers, with 180,000 observations gathered between January 1, 1999 and February 28, 2006, the one-year default rate for B2 rated issuers trading two notches below their Moodys rating was a massive 17.82%. That compares with a default rate of 3.61% for issuers trading flat to their Moodys rating; or 0.59% for those trading two notches rich. In other words, if you held a portfolio of bonds that were trading two notches cheaper than the Moodys rating, you should expect nearly a fifth of them to default within a year. Market implied ratings (MIR) can also be used to predict potential ratings changes. An issuer trading three notches below its Moodys rating is looking at about a 25% chance of downgrade over a one-year horizon, according to MIR data from the same data set.

Valuing a CDSValue at inception is zero no cost to enterValue will change over timeAt inception:E(PV) protection leg = E(PV) premium legMark-to-market (MTM) value is the value the market would pay us to unwind the position

Suppose a 5-year CDS was issued at a 250bp spread. In one year, the spread on the reference entity falls to 100bp. MTM = E(PV) of premium leg of 250bp- E(PV) of 4-year protection leg

New 4-year CDS: E(PV) of premium leg of 250bp- E(PV) of 4-year protection leg

Substituting:MTM = E(PV) of premium leg of 250bp - E(PV) of 4-year premium pmts 100 bp

MTM = E(PV) of premium leg of 150bp

Discount PV of 150bp payments. However, payments are made only until credit event, so:MTM = 150bp * RPV01RPV01 = risky PV01 of a 1bp paid on the premium leg. Calculating the RPV01 requires a model that uses market spreads to determine probability of default. Bloomberg CDWS function

Basket Default Swaps(or default baskets)Synthetic correlation products that redistribute the risk of a portfolio of 5 to 200 CDS.Similar to a CDS, except that the nth credit event is the trigger. The first-to-default (FTD) basket takes the first defaults. Protection seller receives a spread based on the notional value until the nth credit event or maturity.

A basket default swap exposes the protection seller to the tendency of the assets to default together, or default correlation.

Why?Consider a reference portfolio with CDS spreads of 30bp, 30bp, 27bp, 29bp, and 30bp. The FTD basket may pay 120bp. A more risk averse investor could take the second-to-default (STD) basket or lower.

Valuing a Default BasketValue of n A FTD is riskier than a STD and commands a higher spread.Number of credits The more credits in the basket, the greater the likelihood of one or more credit events, so the higher the spread.Credit quality The lower the credit quality of the credits, the higher the spread,

Maturity The effect of maturity depends on the shape the individual credit curves and the correlation of the term structure.Default correlation The greater the default correlation, the greater the spread.

Use of Default BasketsInvestors can leverage credit exposure and get a higher yield without increasing notional at risk.Reference credits are typically investment grade and require little extra analysis.Basket can be customized for the investors exact view regarding notional value, maturity, number of credits, credit selection, and the order of protection (FTD, STD, etc.)

Default baskets can be more cheaply used to hedge a portfolio of credits than hedging individually.Can be used to express a view on default correlation.

Synthetic CDOsSimilar to default basket

Example: 100 CDS pool, $10 million notional value each. 3 tranches:$50 million equity tranche, $100 million mezzanine tranche, $850 million senior tranche

SpreadsEquity tranche: 1500bpMezzanine tranche: 200pSenior tranche: 15bp

A default in 1 of the 100 with a 30% recovery rate ($7 million loss).

Equity tranche loses $7 million of value.Equity tranche notional value is now $43 million. The spread is now paid on this new value of $43 million.

The process is repeated until $50 million losses are incurred. At that point the equity tranche is depleted and losses now accrue to the mezzanine tranche.

CDOs and beyondA CDS is a derivative.CDOs are a double derivative.There are triple derivatives. A CDO made up of CDOs.