Ch6 Credit Derivatives & Credit-Linked Notes (1)

1. Scope of credit derivatives activity

The most popular credit dervaties: CDSs(single-name credit default swaps), portfolio protection products, credit-linked notes, & CDOs(cash collaterialized debt obligations).




2. Single-Name Credit Default Swaps

2-1. Definition: http://www.investopedia.com/terms/c/creditdefaultswap.asp

2-2. Video lecture: http://www.youtube.com/watch?v=P2cUh-e_Qkc
- single reference entity
- most popular form of credit derivatives transaction
- much like an option
- OTC market, but relatively liquid (about 300 out of 1,000 or so in 2003)

2-3. Single-Name CDS Mechanics
2-3-1. Exactly the same way as credit insurance or a financial guarantee

2-3-2. The credit protection purchaser makes a fixed payment (CDS spread) to the credit protection seller in exchange for a contingent payment upon the occurrence of an event of default by a specific obligation (reference asset)

2-3-2-1. Contingent payment:
* cash settled CDSs = par value - current market price (expected recovery)
* physically settled CDSs: delivery of defaluted reference asset & fixed cash payment (par)
* digital CDSs: a fixed cash payment (comparable to a valued credit insurance contract)

2-3-2-2. CDS spread: P.V. of Spread is equivalent to a credit insurance premium

2-3-2-3. Credit protection purchaser need not own the reference asset <-> credit insurance
**if the credit protection buyer owns the asset & believes it can improve on the recovery rate
=> protection buyer: better off

***basket credit CDS: The protection seller writes protection on a portfolio of n-th reference names. In the case of credit event, the value of the pre-specified notional amount (minus the usual value) is paid & the affected reference entity is removed from the basket.

e.g) Trade date: 17/02/2004, Value date: 19/02/2004, Maturity date: 19/02/2009, Notional amounts: $20M, Portfolio notional value: $100M, Settlement: Cash, Premium: 285 bps, recover value: 70%
=> Cash payment = $20M x (1.00 - 0.70) = $6M

***first-to-default(FtD) portfolio CDS: similar to basket credit CDS, on occurrence of a credit event the entire FtD CDS will terminated and settlement will be regard to the entire notional amount following the first credit event affecting one of the refernce entities.

e.g) The underlying: $10M par value of the bonds, Notional amount of the contract: $10M, Swap Premium: 250 pb per annum, 91 actual dats in a quarter
Quarterly Swap Premium = $10M x 0.025 x 91 / 360 = $63,194.44

2-3-2-3. ISDA Trigger Events
ISDA(International Swaps & Derivatives Association)
- Bankruptcy
- Obligation Acceleration
- Obligation Default
- Failure to Pay
- Repudiation/Moratorium
- Restructuring, debatable

2-3-3. Constant Maturity CDS (CMCDS)
The premium paid is variable over the life of the CMCDS contract and resets periodically to some reference fixed CDS.

2-3-4. Bonds vs. CDSs