Credit Default Swap Trading Strategies
©2010
Diplomarbeit
82 Seiten
Zusammenfassung
Inhaltsangabe:Introduction:
Credit default swaps are by far the most often traded credit derivatives and the credit default swap markets have seen tremendous growth over the past two decades. Put simply, a credit default swap is a tradeable contract that provides insurance against the default of a certain debtor.
Initially, when the first form of a credit default swap (CDS) was traded in 1991, they were mainly used by commercial banks in order to lay off credit risk to insurance companies. However, focus shifted in the subsequent years as new players entered the market. Hedge funds became big players, money managers and reinsurers entered, and banks started to not only buy protection on their assets but also sell protection in order to diversify their portfolios. All this led to todays CDS market being dominated by investors rather than banks and, as a consequence, CDSs are now structured to meet investors needs instead of those of the banks.
Over the same time as this shift to an investor orientated market took place, CDS markets grew at an astonishing rate with notional amount outstanding pretty much doubling every year until peaking in the second half of 2007 at USD 62,173.20 billions. The need to effciently transfer credit risk as well as the increasing standardization of CDS contracts by the International Swaps and Derivatives Association propelled this development. Only in 2008 did the notional amount outstanding in CDSs retract for the first time and come down to USD 31,223.10 billion in the first half of 2009. A partial reason was the full blown financial crisis in which CDSs also played a prominent role.
The demise of Lehman Brothers, for example, triggered roughly USD 400 billion in protection payments and American International Group needed to be bailed out in 2008 because it had sold too much CDS protection. Amongst other concerns, these incidents highlight the systemic importance of CDSs. Combined with the phenomenal growth of CDS markets, this makes CDSs a highly relevant component of the current ?nancial environment and a fruitful subject for academic research.
Today, just like most other financial instruments, CDSs serve a multitude of purposes spanning hedging, speculation, and arbitrage. The aim of this thesis is to explore these uses further and answer the following research questions:
What CDS trading strategies are commonly used and how does a selection of these strategies CDS curve trades including forward CDSs, […]
Credit default swaps are by far the most often traded credit derivatives and the credit default swap markets have seen tremendous growth over the past two decades. Put simply, a credit default swap is a tradeable contract that provides insurance against the default of a certain debtor.
Initially, when the first form of a credit default swap (CDS) was traded in 1991, they were mainly used by commercial banks in order to lay off credit risk to insurance companies. However, focus shifted in the subsequent years as new players entered the market. Hedge funds became big players, money managers and reinsurers entered, and banks started to not only buy protection on their assets but also sell protection in order to diversify their portfolios. All this led to todays CDS market being dominated by investors rather than banks and, as a consequence, CDSs are now structured to meet investors needs instead of those of the banks.
Over the same time as this shift to an investor orientated market took place, CDS markets grew at an astonishing rate with notional amount outstanding pretty much doubling every year until peaking in the second half of 2007 at USD 62,173.20 billions. The need to effciently transfer credit risk as well as the increasing standardization of CDS contracts by the International Swaps and Derivatives Association propelled this development. Only in 2008 did the notional amount outstanding in CDSs retract for the first time and come down to USD 31,223.10 billion in the first half of 2009. A partial reason was the full blown financial crisis in which CDSs also played a prominent role.
The demise of Lehman Brothers, for example, triggered roughly USD 400 billion in protection payments and American International Group needed to be bailed out in 2008 because it had sold too much CDS protection. Amongst other concerns, these incidents highlight the systemic importance of CDSs. Combined with the phenomenal growth of CDS markets, this makes CDSs a highly relevant component of the current ?nancial environment and a fruitful subject for academic research.
Today, just like most other financial instruments, CDSs serve a multitude of purposes spanning hedging, speculation, and arbitrage. The aim of this thesis is to explore these uses further and answer the following research questions:
What CDS trading strategies are commonly used and how does a selection of these strategies CDS curve trades including forward CDSs, […]
Leseprobe
Inhaltsverzeichnis
Wolfgang Schöpf
Credit Default Swap Trading Strategies
ISBN: 978-3-8366-4973-5
Herstellung: Diplomica® Verlag GmbH, Hamburg, 2010
Zugl. Wirtschaftsuniversität Wien, Wien, Österreich, Diplomarbeit, 2010
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Contents
1
Introduction
1
2
Credit Default Swaps
4
2.1
Trading Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5
2.2
Legal Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6
2.3
The CDS Markets
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7
2.4
Main Uses of CDSs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8
2.4.1
Speculation with CDSs
. . . . . . . . . . . . . . . . . . . . . . . . . .
8
2.4.2
Arbitrage with CDSs . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8
2.4.3
Hedging with CDSs
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
9
2.5
The Premium Leg
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9
2.6
The Protection Leg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11
2.6.1
Credit Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11
2.6.2
Settlement
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
11
2.7
Forward Starting CDSs
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12
3
Valuation of CDSs
14
3.1
Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15
3.2
Default Probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
16
3.3
Credit Modeling and The Building Blocks . . . . . . . . . . . . . . . . . . . .
16
3.3.1
Zero Recovery Risky Zero Coupon Bond . . . . . . . . . . . . . . . . .
18
3.3.2
The Hazard Rate Model . . . . . . . . . . . . . . . . . . . . . . . . . .
19
3.3.3
Survival Probability . . . . . . . . . . . . . . . . . . . . . . . . . . . .
19
3.3.4
The Value of $1 Paid at Default
. . . . . . . . . . . . . . . . . . . . .
20
i
3.4
Valuing the Premium Leg . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
21
3.4.1
Regularly Scheduled Premium Payments . . . . . . . . . . . . . . . . .
21
3.4.2
Accrued Premium if Default Occurs Before t
n
. . . . . . . . . . . . .
22
3.4.3
Accrued Premia if Default Occurs After t
n
. . . . . . . . . . . . . . .
22
3.5
Valuing the Protection Leg
. . . . . . . . . . . . . . . . . . . . . . . . . . . .
23
3.6
Marking to Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
24
3.7
Valuation of a Forward CDS . . . . . . . . . . . . . . . . . . . . . . . . . . . .
25
4
CDS Curve Trades
27
4.1
Potential Benefits of Curve Trading . . . . . . . . . . . . . . . . . . . . . . . .
28
4.2
Caveats of Curve Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
28
4.3
Measuring the Curve Shape . . . . . . . . . . . . . . . . . . . . . . . . . . . .
29
4.4
Determinants of the Curve Shape . . . . . . . . . . . . . . . . . . . . . . . . .
29
4.4.1
Fundamental Drivers of the Timing of Default and Curve Shape
. . .
31
4.4.2
Upward, Flat and Inverted CDS Curves . . . . . . . . . . . . . . . . .
32
4.5
The Cross Section of CDS Curves . . . . . . . . . . . . . . . . . . . . . . . . .
33
4.5.1
Models for the Cross Section . . . . . . . . . . . . . . . . . . . . . . .
35
4.6
Curve Trading Weighting Schemes . . . . . . . . . . . . . . . . . . . . . . . .
36
4.6.1
DV01 Neutral Weighting . . . . . . . . . . . . . . . . . . . . . . . . . .
36
4.6.2
Notional Neutral Weighting . . . . . . . . . . . . . . . . . . . . . . . .
38
4.6.3
Flat Carry Weighting
. . . . . . . . . . . . . . . . . . . . . . . . . . .
39
4.6.4
Percentage Slope Neutral Weighting . . . . . . . . . . . . . . . . . . .
39
4.6.5
Log Model Weighting
. . . . . . . . . . . . . . . . . . . . . . . . . . .
40
4.7
Profit and Loss Drivers for Curve Trades . . . . . . . . . . . . . . . . . . . . .
41
4.7.1
Time Effects: Carry and Roll Down . . . . . . . . . . . . . . . . . . .
41
4.7.2
DV01 and Convexity . . . . . . . . . . . . . . . . . . . . . . . . . . . .
42
4.8
Steepeners and Flatteners . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
43
4.9
Butterflies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
45
4.10 Forward CDSs
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
46
4.10.1 Overestimating Future Spot Spreads . . . . . . . . . . . . . . . . . . .
46
4.10.2 Trading Forward CDSs
. . . . . . . . . . . . . . . . . . . . . . . . . .
48
ii
5
CDS Basis Trades
49
5.1
The Asset Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50
5.2
The Z-Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
52
5.3
Drivers of the CDS Basis
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
54
5.3.1
Technical Basis Drivers
. . . . . . . . . . . . . . . . . . . . . . . . . .
54
5.3.2
Fundamental Basis Drivers . . . . . . . . . . . . . . . . . . . . . . . .
56
5.4
Trading the Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
5.4.1
Relative Value Trading . . . . . . . . . . . . . . . . . . . . . . . . . . .
58
5.4.2
Enhancing Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60
5.5
Profit and Loss Drivers for Basis Trades . . . . . . . . . . . . . . . . . . . . .
60
5.6
Basis Trading Weighting Schemes . . . . . . . . . . . . . . . . . . . . . . . . .
61
5.6.1
Notional Neutral Weighting . . . . . . . . . . . . . . . . . . . . . . . .
61
5.6.2
Default Neutral Weighting . . . . . . . . . . . . . . . . . . . . . . . . .
62
5.6.3
DV01 Neutral Weighting . . . . . . . . . . . . . . . . . . . . . . . . . .
63
5.7
Basis Trading Risks
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
64
6
Further Strategies
66
6.1
Capital Structure Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . .
66
6.2
CDSs and Equity Puts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
67
6.3
Convertible Bond Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . .
68
7
Conclusion
70
iii
1 Introduction
Credit default swaps are by far the most often traded credit derivatives and the credit default
swap markets have seen tremendous growth over the past two decades. Put simply, a credit
default swap is a tradeable contract that provides insurance against the default of a certain
debtor.
Initially, when the first form of a credit default swap (CDS) was traded in 1991, they
were mainly used by commercial banks in order to lay off credit risk to insurance companies.
However, focus shifted in the subsequent years as new players entered the market. Hedge
funds became big players, money managers and reinsurers entered, and banks started to not
only buy protection on their assets but also sell protection in order to diversify their portfolios.
All this led to today's CDS market being dominated by investors rather than banks and, as a
consequence, CDSs are now structured to meet investors' needs instead of those of the banks
(see Smithson and Mengle, 2006, p. 54f).
Over the same time as this shift to an investor orientated market took place, CDS markets
grew at an astonishing rate with notional amount outstanding pretty much doubling every
year until peaking in the second half of 2007 at USD 62,173.20 billions (see ISDA, 2009).
The need to efficiently transfer credit risk as well as the increasing standardization of CDS
contracts by the International Swaps and Derivatives Association propelled this development.
Only in 2008 did the notional amount outstanding in CDSs retract for the first time and come
down to USD 31,223.10 billion in the first half of 2009. A partial reason was the full blown
financial crisis in which CDSs also played a prominent role.
The demise of Lehman Brothers, for example, triggered roughly USD 400 billion in protec-
tion payments (see Bawden and Jagger, 2008) and American International Group needed to
be bailed out in 2008 because it had sold too much CDS protection. Amongst other concerns,
these incidents highlight the systemic importance of CDSs. Combined with the phenomenal
1
CHAPTER 1. INTRODUCTION
2
growth of CDS markets, this makes CDSs a highly relevant component of the current financial
environment and a fruitful subject for academic research.
Today, just like most other financial instruments, CDSs serve a multitude of purposes
spanning hedging, speculation, and arbitrage. The aim of this thesis is to explore these uses
further and answer the following research questions:
What CDS trading strategies are commonly used and how does a selection of these
strategies CDS curve trades including forward CDSs, and CDS basis trades
work in detail?
To answer these questions, the thesis is structured as follows: Chapter 2 gives an introduction
to CDSs. It explains how CDSs work, what their specific characteristics are and discusses
important legal considerations. CDS markets are described and the main uses of CDSs are
introduced in more detail. Finally, the basic structure of forward CDSs is also introduced.
Chapter 3 then proceeds to present the valuation of CDSs. The risk neutral pricing frame-
work in which valuation takes place is shortly touched upon. Default probabilities or, in other
words, the likelihood that a debtor will not honor its commitments are explained. Various
credit models are introduced and, based on all this, the actual pricing of CDSs, forward
starting CDSs, and their marking-to-market is explained.
Whereas the first two chapters lay out the theoretical foundation, the remaining chapters
cover the trading strategies themselves. Chapter 4 is about CDS curve trades. The CDS
curve, similarly to the term structure of interest rates, gives the price of CDS protection
as a function of maturity. Therefore, any trade that is intentionally exposed to changes in
the CDS curve shape, falls into this category. This chapter discusses benefits and caveats of
trading the curve. Determinants of the curve shape and a model to get a view on possible
curve changes are explained. Once one has a view about how the curve will likely change,
flatteners, steepeners, butterflies or forward CDSs can be used to profit from that view. Since
each of these trades requires multiple CDS positions, various schemes for weighting these
positions relative to each other are then explored. Lastly, profit and loss drivers for curve
trades are analyzed.
Following CDS curve trades, Chapter 5 is all about trading the CDS basis. Loosely defined,
the CDS basis is the difference between the price of credit in the CDS markets as measured
by the CDS spread and the price of credit in the cash markets as measured by the asset swap
CHAPTER 1. INTRODUCTION
3
spread or the Z-spread. Through arbitrage, the price of credit should be the same in the two
markets and the basis be zero if it were not for a variety of technical and fundamental factors
that cause the basis to generally be non-zero. These factors are explained and, following that,
the chapter lines out how to trade the basis, what the profit and loss drivers for basis trades
are, how to choose the weights, and, finally, what the associated risks are.
The purpose of Chapter 6 is to give an outlook to other CDS trading strategies that are
frequently used and to serve as a starting point for further study. One included strategy is
capital structure arbitrage which tries to profit from mispricings between a company's debt
and equity. Another strategy is trading CDSs versus equity puts which tries to profit from
different payoffs in case of default. Lastly, there is convertible bond arbitrage which has the
purpose of gaining cheap exposure to at least one of the underlying risk factors of a convertible
bond credit risk, interest rate risk or equity risk by hedging the others.
Finally, Chapter 7 summarizes and concludes.
2 Credit Default Swaps
This chapter will give an introduction to credit default swaps (CDSs) and try to emphasize
market practices as shaped by the Big Bang protocol since these are most up to date. However,
for comparison, it will also be presented how conventions were before the changes.
"A [credit] default swap is a bilateral contract that enables an investor to buy
protection against the risk of default of an asset issued by a specified reference
entity. Following a defined credit event, the buyer of protection receives a pay-
ment intended to compensate against the loss on the investment. In return, the
protection buyer pays a fee." (O'Kane, 2001a, p. 25)
Economically, therefore, a CDS is very similar to an insurance contract. The protection buyer
receives compensation from the protection seller in the case of some predetermined events for
which a premium has to be paid. The difference is, that with CDSs, the protection buyer does
not actually have to own the underlying asset. Hence, CDSs can not only be used for hedging
but also for speculation and other purposes as described in section 2.4. The mechanics of a
CDS contract are illustrated in Figure 2.1. When a credit event occurs, the protection buyer
gets the right to deliver a particular bond issued by the reference entity and receives the
Fee or premium
Default payment on triggering event
Protection buyer
Counterparty A
Protection seller
Counterparty B
Reference Asset
Figure 2.1: Mechanics of a CDS (source: Choudhry, 2006, p. 9)
4
CHAPTER 2. CREDIT DEFAULT SWAPS
5
Credit
Funding
Interest Rate
Currency
Bond/Loan
Credit
Funding
Asset Swap
Credit
Credit
Derivative
Figure 2.2: CDSs provide the cleanest isolation of credit risk (source: Choudhry, 2006, p. 8)
face value of the bond. The deliverable bond is known as the reference obligation and the
total amount of par value of the bonds that can be delivered is the CDS's notional principal
(see Hull and White, 2000, p. 3). Reference entities are typically corporations, financials or
sovereign issuers. In terms of maturity, the five years are the benchmark maturity in CDS
markets and the most liquid contracts. Other liquid tenors include three, five, seven and ten
years (see Rennison et al., 2008, p. 63).
2.1 Trading Credit Risk
One of the main characteristics of CDSs is that they isolate the default risk of the reference
entity and make it tradeable (see Schönbucher, 2003, p. 15). Blanco et al. (2005, p. 2257),
for instance, suggest that CDS spreads should be used instead of traditional credit spreads
for measuring credit risk because they provide a cleaner indication of the risk of default
associated with an issuer. This is illustrated in Figure 2.2 which compares the risk factors of
bonds, asset swaps, and CDSs. Imagine, for example, the holder of a corporate bond. Besides
liquidity and interest rate risk, the holder is also exposed to credit risk, the risk that the
corporation will default on its promised payments. While "naturally, market forces generally
work so that lenders/investors are compensated for taking on all these risks," (Bomfin, 2005,
p. 4) they also often have the need to manage their exposure to each particular source of
risk. For example, a bank might want to lend to an existing customer but have limited risk
bearing capabilities whereas another bank would like to diversify their credit risk exposure
CHAPTER 2. CREDIT DEFAULT SWAPS
6
without actually having to lend more money. By entering into a CDS both could achieve their
objective. This example illustrates, how CDSs can contribute to a more efficient distribution
of risk in an economy. Nevertheless, it should be noted that the unfunded nature of CDSs
makes it also particularly easy to accumulate and concentrate large amounts of risk as the
financial crisis of 2008 has shown.
Besides providing a way to efficiently spread credit risk, Bomfin (2005, p. 5) and (Choudhry,
2006, p. 60) lists other advantages of CDSs:
· Increased liquidity: While corporate bond markets can be illiquid, shorting corporate
bonds can be even more difficult. CDSs, to the contrary, allow an easy way to go credit
risk both long and short. Furthermore, since none of the counter parties actually has
to own the underlying asset, the notional amount of the contract is virtually unlimited.
· Lower transaction costs: Theoretically, the payoff of a CDS can be replicated through
a position in both a credit risky and a risk-free bond. This, however, requires two
transactions and the ability to short one of the two bonds. These two hurdles are
eliminated through CDSs.
· Access to any part of the term structure: Investors can now trade credit with any tenor
and not just those where borrowers have issued a paper.
2.2 Legal Considerations
CDSs are traded over the counter (OTC) although there have recently been moves towards
a central clearing or even an exchange trading of CDSs. OTC contracts can generally be
negotiated very freely between the counterparties involved. However, these negotiations can
be burdensome and entail a great deal of legal risks. The International Swaps and Derivatives
Association (ISDA) has, as a consequence, published so called Master Agreements to which
each party can subscribe to and that define the legal and credit relationships between the
parties. These master agreements are designed in a modular fashion such that they provide
the necessary flexibility to accommodate many types of transactions while at the same time
ensuring that contracts are standardized enough to be easily tradeable (see ISDA: Allen
Overy, 2002). This has led to the evolution of standard CDS contracts in North America,
Europe and many parts of the world. In a similar fashion, the ISDA also puplishes various
CHAPTER 2. CREDIT DEFAULT SWAPS
7
standard definitions and other terms and provisions for use in documenting different types
of derivatives transactions. The most important examples are probably the 2002 Master
Agreement, the 2003 Credit Derivatives Definitions and the Big Bang Protocol of 2009. An
ISDA protocol is a protocol that contains amendments to existing contracts and to which a
party can unilaterally sign up to. These amendments then come into effect for all the affected
contracts between all the parties that have signed up to the protocol, thereby providing a
cheap and efficient way to change multiple contracts at once.
2.3 The CDS Markets
Since the first modern CDS was traded in 1997 by JPMorgan Chase, these markets have seen a
tremendous growth. "On a gross notional outstanding basis, the market has roughly doubled
in size every year through 2007" (Markit, 2009, p. 4). By the end of 2006 the total size of the
whole credit derivatives markets was $20 trillion of which single name CDSs made up 33%.
This gross notional amount outstanding may be a figure that sounds very impressive due to
its sheer size. Yet, the actual cash flows in the CDS markets, consisting of premium- and
protection payments are much smaller than this figure suggests. Also, despite this amazing
growth, the CDS markets are still small, unregulated and lack standardization when compared
to other derivatives markets. The majority of CDSs is written on non-sovereign entities and
only a very small fraction (10%) is written on entities with a worse than B rating (BBA, 2006,
p. 5f). This is surprising since one could be tempted to think that insurance against default is
more important for entities with a high risk of default. Bomfin (2005, p. 22) cites the "banks'
desire to free up regulatory capital related to loans to [investment grade] corporations so that
capital can be put to work in higher-yielding assets" as a potential reason.
The most important players in CDS markets are banks, insurers, re-insurers and hedge
funds. This comes as no surprise when one considers that CDSs are only in existence for a
short time, traded OTC and less standardized than other financial assets. Banks act as both
buyers of protection and as market makers while insurers sell protection mostly because of
their low correlation with other insured risks and to enhance their returns on capital (see
Bomfin, 2005, p. 23).
CHAPTER 2. CREDIT DEFAULT SWAPS
8
2.4 Main Uses of CDSs
The main uses of CDSs, just as of nearly any other financial asset, can be described as
speculation, arbitrage or hedging. For each of the three uses, there are several ways in which
CDSs can be used and I will only discuss a few here to give some examples. Chapters 4 to 6
will then explain some CDS trading strategies in much more depth.
2.4.1 Speculation with CDSs
The CDS spread is the market price for insurance against default risk by the referenced entity.
If an investor thinks that this price is fundamentally too high or too low, the investor can
enter into a position and hope that market prices will move towards what seems to be the
adequate price.
Also, an investor can have a certain opinion about the future prospects of a company. For
instance, if the investor thinks that the debt servicing capability of a company will deteriorate
or that the company will even default, the investor can buy protection now at the lower
price and sell it again when it has become more expensive or, in case of default, receive the
protection payment.
2.4.2 Arbitrage with CDSs
The term arbitrage in its most stringent use is defined as the the simultaneous buying and
selling of the same security or payoff profile for different prices and in different markets. This
perfect form of arbitrage would yield a profit but require no capital and entail no risk. In
reality, most forms of arbitrage that take place are what is known as risk arbitrage. "Unlike
in the textbook model, such arbitrage is risky and requires capital . . . , [the] arbitrageur does
not make money with probability one, and may need substantial amounts of capital to both
execute his trades and cover his losses" (Shleifer and Vishny, 1997, p. 36).
One possible form of risk arbitrage with CDSs is to exploit deviations of the arbitrage
relationship as described in Hull and White (2000) that a portfolio comprised of a par yield
bond and a long CDS on the same entity is approximately risk-free and should thus yield
the risk-free rate. Any significant deviations of this relationship would create the arbitrage
opportunity to buy the portfolio and short the risk-less asset or vice versa, a strategy known
CHAPTER 2. CREDIT DEFAULT SWAPS
9
as the basis trade and covered in Chapter 5.
2.4.3 Hedging with CDSs
Since CDSs provide such a clean separation of the reference entity's credit risk, they are ideally
suited to hedge just that risk. For example, a hedge fund with a large portfolio of corporate
bonds can reduce its credit risk by buying protection on some or all of the bonds. The fee
for the CDSs is approximately the same as the additional compensation of the bonds above
the risk-free rate for their risk of default which leaves the hedge fund earning approximately
the risk-free rate. In case of default, the hedge fund receives the loss on the bonds from the
protection seller which, again, creates a similar situation to having owned a risk-less bond.
Of course, a CDS can also be used to hedge another CDS, thereby effectively canceling its
payments out. This is particularly easy since the implementation of the Big Bang protocol
because now, spreads are fixed and effective dates are standardized (see Markit, 2009). Take
a big investment bank that has sold CDSs to an insurance company as an example. It receives
100 bps on a notional principal of 100 mn but is obliged to pay a huge sum if the reference
entity defaults. If it does not want to bear that risk, the investment bank can immediately
buy protection from another bank at the same price. In sum, the cash flows are netting out
completely and the position has, at least in theory, no risk. In practice, the investment bank
is still exposed to the risk of default by one of the two counterparties which can be significant.
Payments associated with CDSs can be either premium related payments or protection
related payments. The nature of these payments is rather different which is why they will be
covered separately in the following.
2.5 The Premium Leg
CDS premia, the fee for protection, are expressed in basis points (bps) per year where 1%
equals 100 bps. They are typically paid quarterly, at the end of each premium payment period,
on the notional amount of the CDS contract. Payment dates are similar to the international
money market dates, namely on the 20
th
of March, June, September and December. The
daycount convention is actual/360 and they are either paid until maturity or a credit event,
whichever comes first. In case of default, accrued premium has to be paid for the time between
CHAPTER 2. CREDIT DEFAULT SWAPS
10
the last premium payment date and the time of default. "This is a contingent cash flow which
must be captured by any valuation model for CDS since a CDS contract which does not pay
the coupon accrued at default must have a different present value to one that does." (O'Kane,
2008, p. 85)
Before implementation of the CDS Big Bang protocol, when a CDS was entered, the CDS
spread was set such that the value of the protection leg equals the value of the premium leg
and the contract as a whole had no initial value. This particular spread is called the par
spread. However, as soon as the CDS market spread moved, the contract had no longer a
value of zero. Take, for instance, a protection buyer who entered a CDS at 200 bps. If the
same contract were later trading at 230 bps, anyone who wanted to buy this protection would
then have to pay more for the same protection than what the initial protection buyer had
to pay for the remaining time until maturity. Thus, the contract had a positive value to the
initial protection buyer. The problem with this convention of paying the par spread was, that
it made it more difficult to enter an offsetting position. In the above example, the protection
buyer could choose to offset the CDS long position that costs 200 bps by entering the same
contract in a short position that would pay 230 bps. Assuming no counterparty risk, this
would exactly offset the economic risks of the first transaction but leave an income stream of
30 bps until maturity.
To make this offsetting of positions easier, changes were introduced to CDS conventions
over the course of 2009 and CDSs now trade at fixed coupons and upfront payments rather
than the par spread which makes the initial value of the contract zero. These fixed coupons
are set to 100 and 500 bps for North American investment grade and high yield contracts
respectively. For European contracts, the fixed spreads are 25, 100, 500 and 1000 bps (Markit,
2009, p. 15). Since it will seldom be the case that the par spread exactly equals one of the
fixed spreads at initiation of the contract, the value of the CDS contract at inception will now
not be zero any more. This initial value of the contract is equal to the mark-to-market value
at inception (see Section 3.6) and will be exchanged in an upfront payment which ensures
that the economic value of the transaction is once again zero at initiation of the trade for
both counterparties. The result is that offsetting a position is now much easier because one
needs not to worry anymore about any residual premia. It is worth noting that "although
the standardization of coupons is irrelevant from a present value perspective, the benefits to
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11
the CDS market from an operational perspective are significant" (Markit, 2009, p. 16).
2.6 The Protection Leg
If a so called credit event occurs, the protection seller has to compensate the protection buyer
for incurred losses.
2.6.1 Credit Events
These credit events that trigger the protection payment as defined by the ISDA are:
· Bankruptcy, where the company becomes unable to pay its debt,
· failure to pay, where the reference entity fails to pay after some grace period,
· obligation acceleration and default, where obligations become due earlier due to default
or something else,
· repudiation or moratorium, where the reference entity rejects or challenges the validity
of the obligations, and
· restructuring, a change in the debt obligations of the reference entity
(see O'Kane, 2008, p. 87). Particularly with regard to restructuring, there are different
conventions in North America and Europe because Europe does not have a similar process to
the Chapter 11 bankruptcy in the U.S. that allows firms to go on without having to liquidate
(see Markit, 2009, p. 15). In Europe, bankruptcy before the court usually also means the
liquidation of the company.
2.6.2 Settlement
Generally, there are two ways to settle a CDS: physical delivery and cash settlement. With
physical delivery, the protection buyer delivers deliverable obligations of the reference entity
as specified in the contract with a face value corresponding to the CDS notional amount. In
exchange, the protection buyer receives the face value in cash from the protection seller.
With cash settlement, on the other hand, the protection buyer receives face value less the
recovery price from the protection seller. This recovery price is determined by an auction
(O'Kane, 2008, p. 85f).
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12
Before the CDS Big Bang, physical settlement was market standard. However, this gave rise
to the problem that the notional amount outstanding of a CDS on a particular reference entity
can far surpass the available amount of actually available face value of reference obligations.
A squeeze and artificially elevated price levels were among the potential consequences as
protection buyers rushed to buy deliverable assets in order to deliver them into the CDS. Now,
cash settlement and auctions are a standard feature of CDS contracts. Apart from avoiding
potential squeezes, this "should allow for more transparency in the process and could lead to
recovery rates that are closer to the true economic risk involved in the contracts" (Helwege
et al., 2009, p. 2).
2.7 Forward Starting CDSs
In a standard CDS, the protection starts at the effective date. Since the changes of the Big
Bang protocol, this effective date is always today - 60 calender days (Markit, 2009, p. 13). A
forward starting CDS, to the contrary, is a CDS where the protection starts at some point in
the future but whose terms are already agreed upon today. If there is a credit event before
the forward date, the contract cancels at no cost to either party. If not, the forward contract
behaves as if an ordinary CDS was entered on the forward date (see O'Kane, 2008, p. 151f).
Forward CDSs are similar to other forward contracts in that they allow to lock-in today the
price of protection in the future as it is seen today. Therefore, forward spreads can be seen
as "the market's implied view of where spreads will be in the future" (Rennison et al., 2008,
p. 113). Also, similar to forward interest rates, the shape of the forward curve is sensitive to
the slope of the CDS term structure. For an upward sloping CDS curve, the forward curve
will be steeper and above the CDS curve, whereas for a downward sloping CDS curve, the
forward curve will be flatter and below. For a more detailed discussion of what drives the
shape of the CDS curve and therefore also the shape of the CDS forward curve, see Section
4.4.
To sum up, the main characteristics of CDSs are
· CDS trade at fixed, quarterly premia that are quoted on an annual basis,
· the protection payment is face value minus recovery,
· they are traded OTC,
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13
· they are unfunded, i.e., it costs nothing to enter the contract from a net present value
point of view,
· settlement can be in either cash or physical with recently a move from physical settle-
ment as the standard procedure towards cash settlement,
· reference entities are corporations, financial or sovereign issuers,
· the 5 year contract has the highest liquidity and is considered the benchmark contract
for a given reference entity.
Details
- Seiten
- Erscheinungsform
- Originalausgabe
- Jahr
- 2010
- ISBN (eBook)
- 9783836649735
- DOI
- 10.3239/9783836649735
- Dateigröße
- 1.2 MB
- Sprache
- Englisch
- Institution / Hochschule
- Wirtschaftsuniversität Wien – Department for Finance, Accounting and Statistics, Betriebswirschaftslehre
- Erscheinungsdatum
- 2010 (Juli)
- Note
- 1,0
- Schlagworte
- derivate credit risk speculation hedging
