1. MMA708-ANALYTICAL FINANCE II
COURSE SEMINAR PRESNTATION

2. BY ARCHIBOLD NANA ACHEAMPONG
CREDIT DEFAULT SWAPS BY
ARCHIBOLD NANA ACHEAMPONG

3. SWAP-what is this? A contractual agreement between two parties
They agree to make periodic payments to each other according to two different indices
Counterparty A makes fixed rate payments to Counterparty B and Counterparty B makes floating rate payments to Counterparty A on the same notional, in a plain vanilla interest rate swap.

4. CREDIT DEFAULT SWAP(CDS) ?
Was originally designed by JP Morgan in 1994.
Financial Swap where seller compensates buyer in case of a credit event, such as default.
Buyer pays the spread to seller. Receives payoff from seller on defaults.
Basically it is the transfer of risk from CDS buyer to seller.

5. CREDIT DEFAULT SWAP(CDS) ?
Is a rapidly growing market.
Outstanding CDS amount of $62.2 trillion(by 2007).
Contracts are documented under International Swaps and Derivatives Association(ISDA).

6. CASHFLOWS No Credit Event Credit Event
Regular premium payments, usually quarterly, made by buyer to seller, which is specified at the beginning of the transaction.
Credit Event
Regular premium payments made by buyer up to the time of default.
Payoff paid to buyer by seller

7. HOW IS CDS SETTLED? Physical Settlement Cash settlement
Seller delivers payoff and in return takes debt obligation(bond) of reference entity.
Cash settlement
Seller pays difference between par value and market price of bond.

8. THE LEHMANN BROTHERS
Was the fourth largest investment bank in the US, following Goldman Sachs, Morgan Stanley and Merrill Lynch.
Before bankruptcy on September 2008, had approximately $155 billion of outstanding debt.
Also had about $400 billion notional value of CDS contracts.

9. THE LEHMANN BROTHERS-Disaster?
Not all CDS contracts could be physically settled since there was inadequate outstanding debt to fulfill all contracts.
Necessitated cash settled CDS trades.
An auction set price of $8.625 cents on the dollar for Lehman Brothers debt.

10. THE LEHMANN BROTHERS-Disaster?
Sellers of protection on Lehman Brothers CDS pay cents, instead of $1.
Simply, anyone who held Lehman Brothers bond and had bought protection via CDS contract would receive payoff of cents on a dollar.

11. PRICING CDS
Two theories exist
Probability model
No-arbitrage approach

12. PROBABILITY MODEL
Takes the present value of a series of cash flows weighted by their probabilities of non-default
Takes four inputs to price the CDS
Issue premium
Recovery rate or % of notional repaid in case of default
Credit curve for the reference entity
XIBOR interest rate curve

13. PROBABILITY MODEL
If there is no default, the CDS price would be the sum of the discounted premium payments
Consider a one-year CDS with starting date t0 and four quarterly premium payments occurring at t1, t2, t3 and t4.
let CDS nominal= N and issue premium=c
Size of quarterly premium = Nc/4
Assume defaults can only occur on one of the payment dates.

14. Two possible outcomes
1. there are no defaults, hence four premium payments are made and CDS contract survives until maturity.
2. default occurs on the first, second, third or fourth payment date.

15. PROBABILITY MODEL

16. PROBABILITY MODEL

17. PROBABILITY MODEL

18. Conclusion
CDS, as a credit derivative, can yield great returns to investors, as well as can cause investors to lose greatly.

19. References
Röman, Jan, Lecture Notes For Analytical Finance II (2015)