Cash settlement in CDS

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Cash settlement in CDS:
Physical settlement – This is the most widely used settlement method in which protection buyer delivers the notional amount of the deliverable obligations of the reference entity to the protection seller in return for the notional amount paid in cash. There are many deliverables obligations, which buyers of the protection can choose amongst. Generally, these options include restrictions on the maturity and the requirement that they are pari passu – most CDS are linked to senior unsecured debt.
Pari passu (investopedia definition)- A Latin phrase meaning “equal footing” that describes situations where two or more assets, securities, creditors or obligations are equally managed without any display of preference.
Cash settlement: It is an alternative method of physical settlement and is not that frequent is CDS system but is overwhelmingly used in case of CDOs (‘Collateralized Debt Obligation). In cash settlement cash is made by the protection seller to the protection buyer which equals to par minus the recovery rate of the reference assets. Market analysis and other dealers quotes are needed to calculate the recovery rate.
Suppose a protection buyer purchases a 5 years contract at a spread of 500bp. The face value of protection is $20m. Then the protection buyer has to pay ($20m X .05 X 0.25) = $250000 – ignoring calendar days and day counts. Let’s say after a short duration reference entity faces credit event, which forces for recovery rate calculation, say it is $45 per $100 of face value.
Now protection seller has to compensate the protection buyer for the loss on the face value of the asset received, which will be $11m in this case.
In addition, protection buyer has to pay the premium payment for the period until credit event. In this since credit event occurred within a month time, protection buyer has to pay ($20m X 500bp X 1/12) = $ 83333.33.

There are upfront – CDS as well when protection buyer pays a lump sum amount in the beginning to some specified maturity, there are no more payments required during the period unless a credit event and the cash settlement is processed through standard CDS.
Liquidity in differs from cash credit market in a number of ways. In terms of maturity, the most liquidity CDS market is 5 years contract followed by 3years, 7 years, and 10 years.

Basket Default Swaps:
It is about redistributing the credit risk across a number of different securities. The portfolio can be small as 5 or large as 200 or more credits. Here the redistribution is based on the idea of assigning losses to different securities in a specified priority with some being first and others taking later losses. It is obvious from the notion that it might expose the investors to default together. This points to default correlations, the simplest correlation product is the basket default swap.
A basket default swap is similar to CDS, the difference being that the trigger is the nth credit event in a specialized basket of the reference entities. Generally, basket contains 5 to 10 reference entities. FTD (First to default) basket, n=1, and it is the first credit in a basket of reference credits in a basket of reference credit whose default triggers a payment to the protection buyer. As with a CDS, the contingent payment typically involves physical delivery of the defaulted asset in return for a payment of the par amount in cash. In return for assuming the nth-to-default risk, the protection seller receives a spread paid on the notional of the position as a series of regular cash flows until maturity or the nth credit event, whichever is sooner.
The most that the protect buyer can lose is the par – recovery value of the FTD asset on the face value of the basket.

Credit Default Swap – CDS in terms of Swap+Option (Swaption)

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(This article is under construction)

Key terms: Credit risk, Credit event, and materiality

What are credit derivatives?

It is bilateral contract that transfers certain credit risk on a specified debt obligation between parties. There are different kind of derivatives, credit derivatives (CD) swaps, and CD options. Total return swap is like equity swaps but with early termination clause, credit default swap is for termination payment protection against event, and credit spread forward is forward contracts on yield spreads. There are credit options as well, spread options, options on FRNs and options on assets swaps.

Credit risk: Credit risk is the risk that the market value of financial instrument might change due to the change in credit rating of the instrument or its issuer, or failure by the issuer to meet its contractual obligations (default risk). It is also known as counter party risk. It is simple, market risk is about the return on your money, and credit risk is about return of your money.

Credit events: Credit events are an event, which triggers payment of credit derivatives.

The 6 Credit Events under ISDA Definitions are: (Source: http://credit-deriv.com/isdadefinitions.htm)

  1. Bankruptcy
  2. Obligation Acceleration
  3. Obligation Default
  4. Failure to Pay
  5. Repudiation/Moratorium
  6. Restructuring

Materiality: It requires that a credit event must be associated with significant adverse movement in the price of the reference asset, after allowing for changes in the market prices of otherwise comparable credit risk-free assets as government bonds. This component of maturity is an important element in the definition of credit event. It is designed to prevent either of the parties involved in a credit derivative from declaring a credit event when the event itself does not materially affect the value of the reference asset.

Credit default swaps:

One party (the protection buyer) pays a fixed amount, either in one lump sum or at regular intervals

The other party (the seller) makes a termination payment only if a credit event is triggered by the reference name

It is also known by the name credit swap, credit event triggered swap, default put option………

The CDS allows the protection buyer, for a fee, to transfer the default risk on the reference asset to the protection seller. As with TR swaps, the protection period does not have to match the maturity of the underlying reference asset.

Termination payment: The calculation of the fixed payment is typically expressed in basis points per annum and is calculated on the specified notional amount. The contingent termination payment is commonly based on a formula:

Termination payment = Notional amount (initial value – Recovery value)

Recovery value (RV) is the estimated market price of the reference asset when a credit event has been declared.

Initial value = Any one of the following

  • Par
  • The market price of the reference asset at the start of the swap
  • Some agreed percentage of par, say 98.50% (so amount paid is subject to a deductible or payment threshold of 1.50% in the event of a claim)

CDS pricing – later

Probabilistic valuation , CDS = PV [(100-RV)xP] {Explanation later}

 

Probability of default, P =[{1- 1/(1+sm)^t}]/(1-RV)

Sm=The multiplicative yield spread = (1+Y)/(1+Rf)-1

Y= Yield to maturity on the zero coupon reference asset

Rf= Yield to maturity on risk free zero coupon bond with same maturity

RV= expected recovery value

t= zero coupon maturity in years

 

(This article is under construction)