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)

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