1. Credit Derivatives

2. Credit Derivatives A credit derivative  financial instrument
Allows participants to decouple credit risk from an asset and place it with another party

3. Credit Risk
Credit risk is the risk of loss due to a Debtor's non-payment of a Loan or other line of Credit, either the Principal or Interest (Coupon) or both.
To reduce or strip out Credit risk, Risk Manager may :
Take Collateral
Make loss provisions
Actively manage the Credit Risk Exposure
or use Credit Derivatives : Credit Default Swaps (CDS)

4. Credit Risk Downgrade Risk
- Rating agency reduces debtor’s credit rating
- Reduces value of debt
Default Risk
- Loan not repaid in full
- Future cash flows not certain

5. Rating Agencies Risk is measured by rating agencies - Moody’s - S&P
- Fitch
Rating scales:

6. Types of Credit Derivatives
Credit Default Swap (almost 90% of all transactions)
Dynamic Credit Default Swap
Credit intermediation Swap
Basket Credit Default Swap
Total Rate of Return Swap
Credit (spread) Option
Downgrade Option
Collateralized Instrument
Credit-linked Note
Synthetic Collateralized Debt Obligation

7. Credit Default Swaps CDS7

8. First CDS 
introduced in 1995 by JP Morgan
in an attempt to free up all that capital they were obliged, by federal law, to keep in reserve in case any of their loans went ‘bad’.
Estimated Size of the CDS market (Q1 2008):
USD 65 trillion
Global GDP: USD 55 trillion (2007,IMF)

9. Characteristics of Credit Default Swaps
Market of CDS is divided in three sectors:
Corporates
Bank credits
Emerging markets sovereign
OTC agreement (privately negotiated transactions)
CDS ranges in maturity from one to ten years
Five year maturity is the most frequently traded
CDS provides protection only against previously agreed upon credit events

10. Credit Events According to ISDA 2003 Master Agreement Bankruptcy
(insolvency or inability to pay its debts)
Failure to pay
(principal or interest)
Debt Restructuring
(change in the terms of the debt that are adverse for creditors)
Repayment Acceleration on Default
Repudiation
(sovereign only – indication that a debt is no longer valid)
One of this event has to have happened on the reference entity in order a CDS payment to be made

11. What is a single CDS Bilateral contract
Protection buyer  pays premium to protection seller
Protection seller  contingent payment upon default of reference asset
One party usually owns the Reference asset
Otherwise: transaction does not involve credit exposure  speculation on behalf of both parties
Premium paid is known  CDS Spread

12. Reference Asset Bank loan Corporate debt Trade receivables
Emerging market debt
Convertible securities
Credit exposures from other derivatives

13. CDS Spread Quoted in Basis Points per annum Paid periodically
If corporate quarterly
sovereign  monthly
Credit Spread =Default probability x (1-recovery rate)
Premium = notional amount x CDS spread p.a.

15. Example on Premium of Bulgarian 5Y CDS
Notional amount = USD10,000,000
Spread= 494 b.p.
Premium = notional amount x CDS spread
= 10,000,000 x
= 494,000 p.a.

16. Payoff from CDS The payoff can be defined in terms of
Physical delivery of the reference asset
delivery of the Defaulted Bond for the Par value (no later than 30 days after the credit event) or
Cash Settlement
pays the Protection Buyer the difference between the Par value and (real) Recovery value of the Bond (within 5 days of the credit event)
Settlement terms of a CDS are determined when the CDS contract is written

17. Buyers and sellers of protection

18. Cash Settlement Example Payoff from a Credit Default Swap
Bank A  holds a corporate bond issued by C
Reference asset  Bond C, maturing in two years

19. Cash Settlement Example Payoff from a Credit Default Swap
To reduce credit risk:
Bank A  enters in two year CDS with Bank B, with notional amount 10 millions (protection buyer)
Bank B  contingent payment to A in the event of default of reference asset C (protection seller)

20. Cash Settlement Example Payoff from a Credit Default Swap
Bank A  pays periodically the premium to Bank B
CDS on C is quoted 52 bps (per annum)
Premium= notional Amount x CDS spread
= 10,000,000 x = 52,000

21. Cash Settlement Example Payoff from a Credit Default Swap
After one year:
C defaults on the bond by declaring bankruptcy
Market value  falls to 48.63% of its par value
because
Market expectation is that C will only be able to pay back 48.63% of total outstanding

22. Cash Settlement Example Payoff from a Credit Default Swap
The payoff on default will be calculated as follow
Notional principal x Par Value – Market Value

23. Cash Settlement Example Payoff from a Credit Default Swap
Bank B  makes payment to Bank A
USD 10,000,000 x (100–48.63)/100 =USD 5,137,000

24. Cash Settlement Example Payoff from a Credit Default Swap
Net effect
CDS  allowed Bank A to insulate itself from credit risk by holding the risky bond C
The payoff from sale of reference asset:
USD 10,000,000 x = 4,863,000

25. Cash Settlement Example Payoff from a Credit Default Swap
Bank A receives the recovery rate from the sale of the underlying reference asset USD 4,863,000 and payoff of USD 5,137,000 from Bank B
Total 10,000,000
Bank B acquired the credit risk of holding the bond without actually holding it in return for receiving the premium from BankA

26. Use of CDS Hedging Protection buyer owns the underlying credit asset
Speculation
Protection buyer does not have to own the underlying asset

27. Hedging CDS  manage the credit risk
Protection buyer  hedge their exposure by entering into CDS contract
IF reference asset defaults  the proceeds from CDS will cancel out the losses on the underlying
Protection buyer  will have lost only the payments over that time
IF reference asset does not default  protection buyer makes the payments reducing investments returns but eliminates the risk of loss due to reference entity defaults

28. Speculation
Investor  speculates on changes in an entity’s credit quality
If credit worthiness declines => CDS spread will increase
If credit worthiness increases => CDS spread will decline
Example: a hedge fund believes an Entity will default soon  buys protection

29. Speculation IF reference asset defaults 
Protection buyer will have paid the premium but will receive from the protection seller the notional amount making a profit.
IF reference asset does not default 
CDS contract will run for whole duration without any return

30. Speculation
The hedge fund could liquidate its position after a certain period of time  lock in its gains or losses
IF reference asset is more likely to default => CDS Spread widens
So, hedge fund  sells protection for the rest of CDS duration at a higher rate => makes profit (given that reference asset does not default during this time)
IF reference asset is much less likely to default => CDS spread tightens
So, hedge fund  again sells protection for the rest of CDS duration in order to eliminate the loss that would have occurred