Ch6 Credit Derivatives & Credit-Linked Notes (2)

3. Portfolio Credit Default Swaps

A reference asset => A reference portfolio consisting of multiple names


3-1. Basket CDS
http://www.youtube.com/watch?v=bGEQ_oafeyM

There is more than one reference entity.


3-1-1. Nth to Default CDSs
An nth to default CDS pays off when the nth default occurs in the reference asset portfolio. Once there is a payout for the Nth reference entity, the credit default swap terminates. In a first-to-default basket CDS a payout is triggered after there is a default for only one of the reference entities. There are no other payouts made by the protection seller even if the other four reference entities subsequently have a credit event.


3-1-2. Senior Basket CDSs
There is a maximum payout for each reference entity but the payout is not triggered until after a specified threshold is reached.


e.g.) default result:
Loss result from default of first reference entity = $6M
Loss result from default of second reference entity = $10M
Loss result from default of third reference entity = $16M
Loss result from default of fourth reference entity = $12M
Loss result from default of fifth reference entity = $15M
Max payout for an individual reference entity = $10M
Threshold = $40M
==> $6M + $10M + $10M + $10M + $4M applied to cover the threshold. So, $40M payout when the fifth reference entity defauls.


3-1-3. Subordinate Basket CDS
There is a maximum payout for each defaulted reference entity and a maximum aggregate payout over the tenor of the swap for the basket of reference entities.


e.g.) Maiximum payout: $10M, Maximum aggregate payout: $10M for the above default result
==> a default for the first reference entity: $6M payout & a default for the second reference entity of $10M: $4M & the swap terminates


3-1-4. Correlation Play

e.g.) 20 References @5% probability of default (PD) & a first-to-default CDS
- perfect correlation (=1.0): Default Odds = 5%
- no correlation(=0.0): Default Odds = 1 - 0.95 ^ 20 = 1 - 36% = 64%


20 References @5% PD & a 20th-to-default CDS
- perfect correlation: Default Odds = 5%
- no correlation: Default Odds = 5% ^ 20 = 0%