Credit Derivatives
Credit Derivatives
A credit derivative  financial instrument
Allows participants to decouple credit risk from an
asset and place it with another party
Credit Risk
Credit risk is the risk of loss due to a Debtor's nonpayment 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)
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
Rating Agencies
•Risk is measured by rating agencies
- Moody’s
- S&P
- Fitch
•Rating scales:
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
Credit Default Swaps CDS
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)
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
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(sovereign only – indication that a debt is no longer valid)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
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
Reference Asset
•Bank loan
•Corporate debt
•Trade receivables
•Emerging market debt
•Convertible securities
•Credit exposures from other derivatives
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.
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 0.0494
= 494,000 p.a.
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
Buyers and sellers of protection
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
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)
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 0.0052 = 52,000
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
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
100
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
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 48.63 = 4,863,000
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
Use of CDS
•Hedging
Protection buyer owns the underlying credit asset
•Speculation
Protection buyer does not have to own the
underlying asset
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
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
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
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