Credit Risk

KACZOROWSKA Natalia
MARRAI Gilles
PIERRE Corentin
Financial Modeling & IT
Part one :
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Table of Contents
1. Definition

2. Quantification of Credit Risk
1. Probability of default estimation
2. Default Probabilities and Equity prices
3. Results in Matlab

3. Credit VaR
1. Introduction of the VaR
2. Credit VaR models

4. Credit Risk Losses
1. Estimating credit losses
2. Results in Matlab




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Definition


Credit risk is:

The risk that a loss will be experienced because of a default by the
counterparty in a derivatives transaction.

John C. Hull, Risk Management and Financial Institutions-2007

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Quantification of Credit Risk Probability of default
The Expected Default Losses:

Comparison between corporate bonds price with risk-free bonds price

Same maturity and same coupon

Usual assumption:

Spread between corporate and risk-free bond yields

PV of the cost of defaults is the excess of the price between a risk-free bond and a
corporate bond

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Example:

Bonds Value = 100

One-year risk-free bond (5%):

Similar corporate bond (5.25%) :

PV of the loss from default:

Expected default loss:

Quantification of Credit Risk Probability of default
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Results:


Maturity (years) Risk-free zero rate (%)
Corporate bond zero rate
(%)
Expected default loss (%
of no-default value)
1 5,00 5,25 0,2497
2 5,00 5,50 0,9950
3 5,00 5,70 2,0781
4 5,00 5,85 3,3428
5 5,00 5,95 4,6390
Quantification of Credit Risk Probability of default
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Probability of Default Assuming No Recovery:

Notations:

Y(T): Yield on a T-year corporate zero-coupon bond

Y*(T): Yield on a T-year risk-free zero-coupon bond

Q(T): Probability that corporation will default between time zero and time t

Quantification of Credit Risk Probability of default
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Bonds value: 100

PV of a risk-free zero-coupon bond:

PV of a similar corporate bond:

Expected loss from default:

The value of the bond with a default probability Q(T) :



Quantification of Credit Risk Probability of default
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The cumulative probability Q(T) is the same as the expected percentage loss

The probability of default is obtained by subtracting consecutive cumulative defaults


Year
Cumulative default probability (
% )
Default probability in year (
% )
1 0,2497 0.2497
2 0,9950 0.7453
3 2,0781 1.0831
4 3,3428 1.2647
5 4,6390 1.2962
Quantification of Credit Risk Probability of default
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The recovery rate R is the proportion of the claimed amount received in the event of a
default

In the event of a no default:

In the event of a default:

The value of the bond with a probability Q(T):


Quantification of Credit Risk Probability of default
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Strong assumptions:

The amount claimed in the event of a default equals the no-default value of the bond

The zero-coupon corporate bonds price are either calculable or observalble

Further:

Probabilities of default must be calculated from coupon-bearing bonds

The defaults can happen on any of the bond maturity dates





Quantification of Credit Risk Probability of default
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Merton Model (1974):
Companys equity is an option on the assets of the company
One zero-coupon bond matures at time T
Notation:
V
0
: Value of companys asset today
V
t
: Value of the companys assets at time T
E
0
: Value of companys equity today
E
t
: Value of companys equity at time T
D : Amount of debt interest and principal due to be repaid at time T

V
: Volatility of assets (assumed constant)

E
: Instantaneous volatility of equity

Quantification of Credit Risk Using equity prices
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Thinking:
If V
T
< D: Default on the debt at time T equitys value = 0
If V
T
> D: Repayment at time T equitys value = V
T
D
Firms equity at time (E
T
) = max (V
T
D, 0) call option
Black-Scholes formula:

Where

Quantification of Credit Risk Using equity prices
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As results:
The value of the debt today : V
0
E
0

The risk-neutral probability : N(-d
2
)
Requirement:
V
0
and
V
are not directly observable
E
0
and
E
are observable
Its lemma:
E
E
0
= N(d
1
)
V
V
O
Resolution:
Two equations that must be satisfied by V
0
and
V



Quantification of Credit Risk Using equity prices
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The CREDIT VaR - Introduction
The Value at Risk definition:
A loss that will not be exceeded at some specified confidence level
John C. Hull, Risk Management and Financial Institutions-2007
The Value at Risk interpretation:
We are X percent certain that we will not lose more than V dollars in the next N
days
V is the VaR of the portfolio,
N is the time horizon,
X is a the confidence level (usually 99.9%)


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MARKET VaRs illustration:
We consider the change in the value of the portfolio
The distribution is the portfolios daily gain
The losses are counted as negative gains
The distribution approximately follows a normal law




Calculation of VaR from the probability distribution of the change in the portfolio
value; confidence level is X%
The CREDIT VaR - Introduction
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CREDIT VaR is defined in the same way than MARKET VaR:
Credit VaR is the credit loss that will not be exceeded over some time horizon with a
specified confidence level
A credit VaR with a confidence level of 99.9% and a one-year time horizon is the
credit loss that we are 99.9% confident will not be exceeded over one year
However:
Time horizon for market Risk is usually between one day or one month
Time horizon for credit Risk is usually much longer-often one year
Several ways to calculate the credit VaR
Make the difference between trading book and banking book


The CREDIT VaR - Introduction
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The CREDIT VaR - The VaR Models
Important difference between trading book and banking book:
The 1996 Amendment (Basel Agreements) distinguishes between a banks trading
book and its banking book
The banking book:
It consists primarily of loans
Not marked to market (Fair Value) for managerial and accounting purposes
The trading book:
It consists of the myriad of different financial instruments
(stock, bonds, swaps, forward contract, exotic derivatives, etc.)
Instruments traded by the bank
Usually marked to market daily
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For regulatory purposes- prescribed by the Basel Committee -:
Banks use the internal ratings based (IRB) approach
Banks have to calculate the credit VaR for items in the banking book
Vasiceks Model provides an easy way to estimate credit VaR for a loan portfolio
The VASICEKs Model:
Using a one-factor Gaussian copula model of time to default
There is a probability X that the percentage of defaults on a large portfolio by time is
less than





| |
|
|
.
|

\
|

+
=

1
) ( ) (
) , (
1 1
X N T Q N
N X T V
The CREDIT VaR - The VaR Models
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The VASICEKs Model:


Q(T) is the cumulative probability of each loan
T is the time of default (usually 1 year)
Is the copula correlation
X is the confidence level (usually 99.9%)

Multiplied by the average exposure per loan and by the average loss given default
This gives the T-year VaR for an X% confidence level




| |
|
|
.
|

\
|

+
=

1
) ( ) (
) , (
1 1
X N T Q N
N X T V
The CREDIT VaR - The VaR Models
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Note about the copula correlation :
It is determined by the Basel Committee
It measures the correlation between each pair of obligors
It depends on the one-year probability of default
The formula is:



( )
PD
e

+ =
50
1 12 . 0
The CREDIT VaR - The VaR Models
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Credit Risk Plus Model:
A similar approach for calculating credit VaR for the banking book
Used in the insurance industry
Proposed by Credit Suisse Financial Products in 1997
A simplified version of the approach is

Where
N is the number of counterparties
PD for each counterparty in time T is p
The expected number of default () for the whole portfolio is given by =Np


! n
e
n

The CREDIT VaR - The VaR Models
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Credit Risk Plus Model:
So the probability of n defaults is given by the Poisson distribution

The CREDIT VaR - The VaR Models
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The trading book involves a specific risk:
Specific risk is related to the credit quality of individuals companies
Banks use CreditMetrics model, proposed by J.P. Morgan in 1997
This involves simulating rating change for companies
Internal model with more freedom than standard VASICEKs Model
CreditMetrics is based on an analysis of credit migration
The probability to move between two rating categories during a period of time
Moodys proposed a ratings transition matrix

The CREDIT VaR - The VaR Models
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CreditMetrics Model:
This involves estimating a probability distribution of credit loss
This is simulating credit rating changes of all counterparties throughout the year
The credit loss is the difference between:
The credit rating at the beginning of the year
The credit rating at the end of the year
Rating transition matrix: Probabilities expressed as percentages


Aaa Aa A Baa Ba B Caa Default
A 0.05 2.39 91.83 5.07 0.5 0.13 0.01 0.02
B 0.01 0.03 0.13 0.43 6.52 83.20 3.04 6.64
The CREDIT VaR - The VaR Models
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Illustration:
We simulate the rating change of an A-rated and B-rated company (1-year)
The variable X
a
determines the new rating of the company A
The variable X
b
determines the new rating of the company B
Since for the company A:
N
-1
(0.0005)=-3.2905
N
-1
(0.0005+0.0239)=-1.9703
N
-1
(0.0005+0.0239+0.9183)=1.5779
The A-rated company gets upgraded to Aaa if X
a
< -3.2905, Aa if -3.2905<X
a
<-1.9703
and A if -1.9703<X
a
<1.5779


The CREDIT VaR - The VaR Models
LOGO
Illustration:
And for the company B:
N
-1
(0.0001)=-3.7190
N
-1
(0.0001+0.0003)=-3.3528
N
-1
(0.0001+0.0003+0.0013)=-2.9290
The B-rated company gets upgraded to Aaa if X
b
< -3.7190, Aa if -3.7190<X
b
<-3.3528
and A if -3.3528<X
b
<-2.9290
The default rate is obtained in the same way:
The A-rated company defaults if X
a
> N
-1
(0.9998) = 3.5401
The B-rated company defaults if X
b
> N
-1
(0.9336) = 1.5032



The CREDIT VaR - The VaR Models
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Conclusion:
Calculate a one year VaR for portfolio using CreditMetrics involves:
Monte Carlo simulation of ratings transitions for bonds in the portfolio
On each simulation trial the final credit rating of all the bonds is calculated
The 99% worst results is the one-year 99% VaR


The CREDIT VaR - The VaR Models
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Note about the Monte Carlo simulation:
Suppose we wish to calculate a one-day VaR for a portfolio:
1. Value the portfolio today in the usual way using the current values of the market
variables
2. Sample once from the multivariate normal probability distribution of the X
i

3. Use the sampled values of the X
i
to determine the value of each market
variable at the end of one day
4. Revalue the portfolio at the end of the day in the usual way
5. Substract the value calculated in Step 1 from the value in Step 4 to determine a
sample P
6. Repeat Steps 2 to 5 many times to buil up a probability distribution for P

The CREDIT VaR - The VaR Models
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Note about the Monte Carlo simulation:
The VaR is calculated as the appropriate percentile of the probability distribution of
P
For example:
We calculate 5000 different samples values of P:
The one-day 99% VaR is the 50th worst outcome
The one-day 95% VaR is the 250th worst outcome

The CREDIT VaR - The VaR Models
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Credit Risk Losses - Estimating Credit Losses
Before:
Probability of default (PD) & Recovery rate (R)
Now:
Estimation of the expected loss in the event of default
Known as the loss given default or LGD
A way to reduce contracts following the expected credit losses
The LGD on a loan is defined by:

The expected loss is PD x LGD

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Derivatives transactions:
Credit exposure is more complicated on derivatives than on a loan
Claim within the event of a default is more uncertain than on a loan
Three possible situations:
1. The contract is always a liability to the financial institution
Short option position No claim, no credit risk
2. The contract is always an asset to the financial institution
Long option position Claim, credit risk
3. The contract can become either an asset or a liability
Forward contract or Swap Credit risk or not
Credit Risk Losses - Estimating Credit Losses
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How to adjust the value of a derivative to allow for credit risk ?
The risk-neutral expected loss from default at time t
i
is

denotes expected value in a risk-neutral world
Taking present values leads to the cost of default:


Where is the value today of an instrument and

Credit Risk Losses - Estimating Credit Losses
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Consider again the three categories:
1. The contract is always a liability to the financial institution
The value of f
i
is always negative
The total expected loss from defaults is always zero
No adjustments for the cost of default
2. The contract is always an asset to the financial institution
The value of f
i
is always positive
The expression max(f
i
,0) is always equal to f
i

Since v
i
is the present value of f
i
, it always equals f
0
The expected loss from default is



Credit Risk Losses - Estimating Credit Losses
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Example:
Consider a two-year over-the-counter option with a value of $3
The probability of default is 4%
The recovery rate is 25%
The expected cost of defaults is
3 x 0.04 x (1 - 0.25) = $0.09
The buyer of the option should therefore be prepared to pay only $2.91
So the contract can be reduced following these expected credit losses
Credit Risk Losses - Estimating Credit Losses
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3. The contract can become either an asset or a liability
The sign of f
i
is uncertain
One way of calculating all the v
i
is to simulate the underlying market variables
over the life of the derivative
Another way can be a historical simulation approach

Credit Risk Losses - Estimating Credit Losses
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Consider a plain vanilla interest swap
Roughly done features of a plain vanilla swap:
A fixed rate of interest is exchanged for LIBOR
Both interest rates are applied to the same notional principal
A company A pays the LIBOR and receive a fixed rate of interest 5%
A company B pays a fixed rate of interest 5% and receives LIBOR



Credit Risk Losses - Estimating Credit Losses
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Features of contract for a company A:
Example from the book Risk Management & Financial institutions by John C. Hull
Pays a fixed rate of interest of 5%
Receives LIBOR
Interest rates are reset every six months
The notional principal is $100
The swap lasts for three years
The swap is entered into on March 5, 2007 until on March 5, 2010

Credit Risk Losses - Estimating Credit Losses
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As results:
No adjustments for the cost of default for Mar. 2003 and Sep. 2003
Adjustment for the cost of default for Sep. 2004, Mar. 2005, Sep. 2005 and Mar. 2006

Credit Risk Losses - Estimating Credit Losses
SWAPS
KACZOROWSKA Natalia
MARRAI Gilles
PIERRE Corentin
Financial Modeling & IT
Part two :
LOGO
Table of Contents
1. Definition
2. Different types of Swaps
3. Swaps utilization
4. The Swaps Market
5. Swaps pricing
6. Swaps risks
7. Interest Rate Swap (Plain Vanilla interest rate swap)
8. Currency Swap
9. Commodity Swap
10. Credit Default Swap
11. Equity Swap
12. ISDA Documents

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Definition
Financial derivative
Agreement between 2 parties to exchange sequences of cash flows for a set period of
time
Benefits depend on the type of financial instrument involved
Settlement dates
Settlement periods
Notional principal
Usually OTC lot of different structures and products (apart of certain type of swaps
such as CDS for instance)

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Different types of Swaps
Interest Rate swaps
Currency swaps
Commodity swaps
Credit Default swaps
Equity swaps
Others :
Total return swap
Swaption (option on a swap)
Variance swap
Amortising swap
Zero coupon swap
Deferred rate swap
Accreting swap
Forward swap



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Swaps utilization
Commercial needs
Comparative advantage
Acquiring certain types of financing (Convert financing into the desired type)
Fixed rate vs floating rate
Ex : a famous US company expansion in Europe
More favourable financing in US
Using a currency swap with better conditions
Hedging (interest rate risks, ...)
Speculate on changes in the expected direction of underlying prices
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The Swaps market
Usually used by firms and financial institutions
Few individuals


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Swaps pricing
Pricing a swap is calculating the fair fixed rate i.e. calculate a fixed rate whereby market
participants are indifferent between paying (receiving) this fixed rate over time or paying
(receiving) a rate that can fluctuate over time
This is accomplished by setting the value of the swap equal to zero at origination
This is achieved when the present value of the two (expected) cash flow streams equal each
other
Because a swap is equivalent to an asset and a liability, we can value each of them to
determine the value of the swap at any moment
Swaps can be priced using bonds because they can be seen as being in a long position in a
bond (in one currency, interest rate, ...) and short in another bond (other currency, other
interest rate, ...)
More generally, the cash-flow stream of a swap can often be considered as a stream of
forward contracts
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Swaps risks
Customized contracts Generally OTC market Entail credit risk
Potential losses from defaults on a swap are much less than the potential losses from defaults on
a loan with the same principal because, usually, the value of the swap is only a small part of the
value of the loan
Potential losses from defaults on a currency swap are usually greater than on a interest rate swap
because the principal amounts in a currency swap are generally exchanged at the end of the life
of the swap which is not the case for a interest rate swap currency swap value are usually
greater than interest rate swap value
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Swaps risks
Swaps (especially OTC ones) might involve liquidity risk
Credit risk are not easy to hedge but market risk can be hedged by entering into
offsetting contracts i.e. Liquidate a futures position by entering an equivalent, but
opposite, transaction which eliminates the delivery obligation
The offsetting swap exactly counters the interest rate (or other market risk) of the
pre-existing swap but does not cancel the earlier swap (it does not eliminate all risk
of the earlier position)



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Swaps risks
Market
risk
For the floating leg and
fixed leg
Due to movement of
underlyning index
(LIBOR)
Hedging by taking
offsetting positions in
some combination of
currency futures, bond and
interest rate futures, currency
forward contracts,
spot currency and bond
markets
Credit
risk
For any counterparty
The exposure to the risk of
failure of the other
counterparty
The cause OTC market,
unstandardized products
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Interest Rate Swap
Interest rate cash flows exchange
Specified notional amount (generally not exchanged ; only for calculation)
Fixed rate Floating rate
Floating rate Fixed rate
Floating rate Another floating rate
Use for both hedging and speculating
Interest rate swap market : largest component of the global OTC derivative market
Notional amount outstanding 2009 (BIS) : $342 trillion
Gross Market Value : $13,9 trillion (06/2009)
Can be traded as an index through the FTSE MTIRS Index
A Plain vanilla swap is the most common type of swap. It is the exchange of a predetermined
fixed rate with a floating rate for the same period of time (and same notional)
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Interest Rate Swap - Example
Intel is currently paying floating interest rate but wants to pay fixed rate and Microsoft wants
the opposite
Party Intel agrees to pay Party Microsoft periodic fixed interest rate payments of 8,65%, in
exchange for periodic variable interest rate payments of LIBOR + 70 bps
Intel pays fixed rate to Microsoft called the swap rate (receives variable rate)
Microsoft pays floating rate to Intel indexed such as LIBOR (receives fixed rate)
Intel is called the payer
Microsoft is called the receiver
The nominal amount is $100 M
We can say that :
Microsoft has lent Intel $100M at 8,65%
Intel has lent Microsoft $100 M at LIBOR + 70 bps
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Interest Rate Swap - Example
Floating interest rate
Floating interest rate
Fixed interest rate
Fixed interest rate
Initially
Finally
Note : LIBOR 03/01/2012 12M : 1,58357 %
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Interest Rate Swap - Example
We can say that :
Microsoft has lent Intel $100M at 8,65%
Intel has lent Microsoft $100 M at LIBOR + 70 bps
Therefore, we can alo say that Microsoft has purchased a $100M floating-rate (LIBOR
+70bps) bond from Intel and sold a $100M fixed-rate (8,65%) bond to Intel
The value of the swap to Microsoft is therefore the difference between the values of 2 bonds

LOGO
Interest Rate Swap - Pricing
Formulas:
V = B
fix
B
fl

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Currency Swap
Foreign exchange agreement
Exchange principal and/or interest in one currency for principal and/or interest in another
currency
Usually exchanged at the beginning and at the end of the life of the swap with the aim of
providing financing in other currency
Motivated by comparative advantage
Main uses :
Secure cheaper debt
Hedge against exchange rate fluctuations
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Currency Swap - Example
Consider a 5-year currency swap agreement between IBM and British Petroleum entered
into on February 1, 2001
IBM :
Pays a fixed rate of interest of 11% in
Receives a fixed rate of interest of 8% in $
Interest rate payments are made once a year and the principal amounts are $15 million and
10 million
Fixed-for-fixed currency swap because the interest rate in both currency is fixed

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Currency Swap - Example

At the outset of the swap IBM pays $15 M and receives 10 M
Each year, IBM receives $1,2 M (8% of $15 m) and pays 1,1 (11% of 10 M)
At the end of the swaps life, IBM pays a principal of 10 M and receives a principal of $15 M
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Currency Swap Comparative advantage

Example :
Consider the 5-year fixed-rate borrowing costs to GM (USD) and QA (AUD)



AUD rates > USD rates
GM more creditworthy than QA (lower rates in both currencies)
Trader point of view : spread between the rates paid by GM and QA in the 2 markets are not the
same ; USD : QA - GM = 2% ; AUD : QA GM = 0,4%
GM have a comparative advantage in the USD market
QA have a comparative advantage in the AUD market


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Currency Swap Comparative advantage

We suppose that GM wants to borrow 20 M AUD and QA wants to borrow 12 M USD
Currency exchange rate 0,6 USD/AUD
Perfect situation for a currency swap :
GM and QA each borrow in the market where they have a comparative advantage
GM borrows in the USD market
QA borrows in the AUD market
Then they use a currency swap to transform their loan into other currency
The total gain to all parties could be expected to be 2% - 0,4% = 1,6% per annum depending on the
swap used

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Currency Swap Valuation

If we consider the default risk t be inexistent, a currency swap can be decomposed in two
bonds
Consider the position of IBM in the previous example (after exchange of the principal)
It is short a GDP bond that pays 11% interest per annum and long a bond in USD that pays 8%
per annum
Vswap : value of the swap in USD (where USD are received and a foreign currency is paid)
BD is the value of the USD bond underlying the swap
BF is the value (measured in foreign currency) of the foreign-denominated bond underlying
the swap
S0 is the spot exchange
Vswap = BD - S0BF
If USD are paid and foreign currency is received, then Vswap = S0BF - BD



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Currency Swap Valuation

Example:
R Japan = 4% per annum
R USA = 9% per annum
Financial institution has entered into a currency swap in which it receives 5% per annum in yen and
pays 8% per annum in dollars once a year
The principals in 2 currencies are $10 M and 1,200 M yen
The swap lasts 3 years and the current exchange rate is 1$ = 110 yen



The value of the swap in dollar is then :
If the FI had been paying yen and receiving dollars, the value of the swap would have been 1.543
M dollars


LOGO
Commodity Swap
Agreement whereby a floating (or market or spot) price based on an underlying commodity is
exchanged for a fixed price over a specific period
Similar to a fixed-for-floating interest rate swap
The difference is that in a fixed-for-floating interest rate swap the floating leg is based on
standard interest rates (e.g. Libor) where in a commodity swap the floating leg is based on the
price of the underlying commodity (e.g. oil or sugar)
No commodities are usually exchanged during the trade
The user of a commodity would secure a maximum price and would get payments based on the
market price for the commodity involved
On the other side, the producer of a commodity wishes to fix his income and to receive fixed
payments for the commodity
The vast majority of commodity swap involve oil
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Commodity Swap - Pricing
Si : spot price of a commodity at the beginning of period i
N : number of units of the commodity
X : fixed price for the commodity
M : total of payments (beginning one period from now)
Cash flow for the party that is long : CF = N*(0, S1-X, S2-X, ..., SM-X)
CF can be decomposed into a stream of fixed payments of NX that we can easily price and a
stochastic stream N(0, S1, S2, ..., SM)
The stochastic stream can be seen as to be equivalent to a stream of forward contracts on N
units of the commodity
Receiving N Si at period i has the same value that receiving N Fi at time i where Fi is the date 0
forward price for delivery of one unit of the commodity at date i
and X is usually chosen so that the initial value of V is zero

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Credit Default Swap
A CDS is an agreement in which the seller will compensate the buyer in the event of a loan
default
The buyer of the CDS makes a series of payments (the CDS fee or spread) to the seller and, in
exchange, receives a payoff if the loan default
In the event of default, the buyer receives the compensation (usually the face value of the
loan) and the seller takes possession of the defaulted loan


LOGO
Credit Default Swap
Outstanding CDS amount (end 2007) : $62,2 trillion
Outstanding CDS amount (mid-year 2010) : $26,3 trillion
Most CDS are documented using standard forms promulgated
by the International Swaps and Derivative Association (ISDA)
but some are tailored to meet specific needs
In addition to the basic single-name swaps, there are a lot of
other different swaps such as basket default swaps (BDS),
index CDS, funded CDS and loan-only CDS
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Credit Default Swap
However, anyone can purchase a CDS even if he does not hold the loan instrument and who
has no direct insurable interest in the loan (called naked CDS); in that case, there is a
protocol to hold a credit event auction and the payment is usually substantially less than the
face value of the loan
The European Parliament has approved a ban on naked CDS since the end of 2011 but it only
applies to debt on sovereign nations
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Credit Default Swap - Risk
Systematic risk for the economy (multi-trillion dollar size of the market)
During the 2007-2010 financial crisis, the lack of transparency became a concern to regulators
Both buyer and seller of credit protection take on counterparty risk
The buyer takes risk that the seller may default
The seller takes risk that the buyer may default
The seller would try to hedge his exposure by buying an offsetting protection from another party
He could also sell the CDS to a third party but it could generate high losses
There is also a jump risk (or jump-to-default risk). The seller could expect a little probability of
default and if it appears, it creates a sudden obligation of payments for a substantial amount (could
be million of billion of $) which is not the case in other OTC derivatives.
There is a project to require the CDS to be traded and settled via a central exchange/clearing
house and there will no longer be counterparty risk as this risk will be held by that institution
CDS (especially OTC ones) might involve liquidity risk
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Credit Default Swap and Insurance
CDS could be compared with insurance. However, there are differences :
The main difference is simply that an insurance contract provides an indemnity against the losses
actually suffered by the policy holder whereas the CDS provides an equal payout to all holders,
calculated using and agreed, market-wide method
There is also differences in the pricing approach. The cost of insurance is based on actuarial analysis .
CDS cost is determined using financial models and arbitrage relationships with other credit market
instruments (such as loans and bonds from the same reference entity)
The buyer of the CDS does not need to hold the underlying whereas for purchasing in insurance the
insured is expected to own a debt obligation
The seller of a CDs does not need to be a regulated entity
The seller is not always required to maintain any reserves to pay off the buyer (although major CDS
dealers are subject to bank capital requirement)
Insures manager risk primarily by setting loss reserves based on the Law of Large numbers while CDS
dealers manage risk primarily by means of offsetting CDS (hedging) with other dealers and
transactions in underlying bond markets
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Credit Default Swaps - Uses
Speculation
Speculation on change on CDS spreads or of market indices (North American CDX index or European
iTraxx index)
If an investor believe that an entitys CDS spreads are too high or too low relative to the entitys bond yields and attempt to profit from that
view by entering into a trade, known as a basis trade, that combines a CDS with a cash bond and an interest rate swap
An investor might speculate on an entitys credit quality, since generally CDS spreads increase as
credit-worthiness decrease and decline as credit-worthiness increase. The investor might therefore
buy CDS protection on a company to speculate that it is about to default
Example:
An investor believes that Company A will soon default on its debt. Therefore, he buys $10 M worth of CDS
protection for two year from Bank B, with Company A as the reference entity, at a spread of 500 bps p.a
If Company A default after 1 year (for instance), the investor will have paid $500 000 and will make a profit of
$10M $500 000 = $9 500 000 and Bank B will incur a $9,5 M loss (unless it has offset its position)
If Company A does not default after the 2 year, the investor will have paid $1M and will therefore lose it totally
while Bank B will have a profit of the same amount
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Credit Default Swaps - Uses
Hedging
A bank for instance may hedge its risk that a borrower may default on a loan by entering in a CDS as
the buyer of protection
Another kind of hedge is against concentration risk. A banks risk manager may advise that the bank
is overly concentrated with a particular borrower or industry. The bank can then lay off some of this
risk by buying CDS. Because the borrower is not a party in the CDS, entering into it allows the bank
to achieve its diversity objectives
Similarly, a bank can sell CDS to diversify its portfolio by gaining exposure to an industry in which the
selling bank has no customer base
Most financial entitys think that using CDS as a hedging device has a useful purpose
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Credit Default Swaps - Uses
Hedging
Example:
A pension fund owns 5-year bonds issued by Company A with par value of $10 M
To manage the risk that Company A could defaults on its debt, the pension fund buys a CDS
from Bank B for a notional amount of $10 M at a spread of 200 bps p.a.
If Company A does not default on its bond payments, the pension fund pays $200 000 a year
for 5 year ($1 M) and receives $10 M from Company A after that 5 years
If Company A defaults on its debt after 3 years (for instance), the pension fund would stop
paying its fees ($600 000 already paid) and is refunded with its $10 M - $600 000 = $9,4 M
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Credit Default Swaps Pricing and Valuation
The probability model :
4 inputs :
The issue premium
The recovery rate (% of notional repaid in event of default)
The credit curve (for the reference entity)
The Libor curve
If no default : price of the CDS would be = sum of the discounted premium payments
Case of 1-year CDS with effective date t0 with 4 quarterly payments occurring at time t1, t2, t3 and t4
Nominal = N and issue premium = c (each quarterly payments = Nc/4)
For simplicity, we assume that defaults can only occur on one of the payment dates
5 ways that the contract could end:
No default : 4 premium payments made and the contract survive until maturity date
A default occurs on the first, second, third or fourth payment date
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Credit Default Swaps Pricing and Valuation
The probability model :
We assign probability to
the 5 possible outcomes
and calculate the PV of the
payoff for each outcome
The PV of the CDS = PV of
the 5 payoffs * probability
of occurring
Probability of surviving over
the interval ti-1 to ti without
default is pi
Probability of default = 1-pi
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Credit Default Swaps Pricing and Valuation
The probability model :
Discount factor is
d





p1, p2, p3 and p4 are calculated using the credit spread curve
The probability of no default occurring between t and t + t decays exponentially with a time-
constant determined by the credit spread
Mathematically p = exp(-s(t)t/(1 R)) where s(t) is the credit spread zero curve at time t
The riskier the reference entity the greater the spread and the more rapidly the survival
probability decays over time
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Credit Default Swaps Pricing and Valuation
The probability model :
To get to total PV of the CDS we multiply the probability of each outcome by its present value to give







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Equity Swap
The 2 parties make a series of payments to each other with at least one set of payments
determined by a stock or a index return
The other set of payments can be a fixed or floating rate or the return on another stock or
index
Equity swaps are used to substitute for a direct transaction in a stock
Equity swaps can avoid transaction costs (including tax) or locally based dividend taxes
There are different types of equity swap :
Equity return paid against a fixed rate
Equity return paid against a floating rate
Equity return paid against another equity return
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Equity Swap
Example:
Equity return paid against a fixed rate
On 15/12/2000, Dynamic Money (US) enters into a swap for one year to pay a fixed rate of 5% and
receive the return on the S&P 500 with payments to occur on 15/03, 15/06, 15/09 15/12
The counterparty is Total Swaps, Inc. ; Notional amount : $20 M
The S&P 500 is at 1105.15 on the day the swap is initiated



The CF are as follow :
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ISDA Documents
The International Swaps and Derivatives Association (ISDA), founded in 1985, has worked to
make OTC derivatives markets safe and efficient
ISDAs pioneering work in developing the ISDA Master Agreement and a wide range of
related documentation materials, and in ensuring the enforceability of their netting and
collateral provisions, has helped to significantly reduce credit and legal risk
The ISDA netting act model defines all terms used in the ISDA Master Agreement or other
documents such as the cleared derivatives execution agreement, the Americas Interdealer
Master Equity Derivatives Confirmation Agreement, specific continents derivatives template,
ISDA Credit Derivatives Definitions or the pre-confirmation trade agreements.
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ISDA Documents
The International Swaps and Derivatives Association launched in 2007 a standard template
for credit default swaps (CDS) on European leveraged loans, which are used by private equity
firms to fund buyouts.
The parties to the default swap can agree that a contract will be canceled if that loan is
subsequently refinanced. Alternatively, the contract will continue, referencing the new loans
used to refinance the original underlying obligation.
Standardization has proved to be a powerful force in the broader bond CDS market, leading
to the creation of benchmark traded indexes such as the iTraxx Crossover and Europe --
credit's equivalent of the FTSE 100 or Dow Jones industrial average.
ISDA provides both Standard Terms Supplement and Confirmation for European CDS.