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Credit Default Swaps - Pricing, Valuation and Investment Applications

Application of Bloomberg CDS pricing tool

Term Paper 2010 25 Pages

Business economics - Investment and Finance

Excerpt

Table of contents

List of figures

1. Introduction

2. Literature Review

3. Application

3.1 Development of the CDS Market

3.2 Pricing and Valuation of CDS

3.3 Risk Management and Investment Applications

4. Conclusion

Appendices

References

List of figures

Figure 1 Typical CDS transaction, Source: Hull (2010) 2

Figure 2 CDS Market size, Source: IASD (2010) 3

Figure 3 CDS Market - Biggest movers, Source: Bloomberg (2010)

Figure 4 CDS Bloomberg pricing tool, Source: Bloomberg (2010)

Figure 5 Counterparty risk in CDS transaction, Source: Hull (2010)

Figure 6 Payoff structure and default probability of CDS contract, Source: adjusted from Hull (2010)

1. Introduction

A credit default swap (CDS) is a bilateral agreement designed explicitly to shift credit risk between two parties. In a CDS, one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity”. (ISDA, 2010)

Credit Default Swaps (CDS) are by far the most popular credit derivatives and have proven to be the most successful financial innovation. The structure of CDS is somewhat similar to the insurance policy. The market of CDS has heavily expanded and is traded in Over-The- Counter (OTC) market.

This essay will briefly address the structure and the market of CDS, outlining its common products usage by some large institutions. Following the review of financial structure and pricing of CDS. And finally, this essay will also evaluate the risk management and investment applications of such products.

2. Literature review

Credit default swaps are credit derivatives which are tradable in the over-the-counter (OTC) market. CDS deliver remarkable value to the worldwide economy. CDS have formed a liquid, vibrant marketplace for trading and or offsetting credit risk, outstripping principal market volume. They have the attributes almost similar to as of insurance. In general terms, during the duration of CDS, one party (generally referred to as the protection buyer) pays a periodic fee or a premium to the other party (usually known as the protection seller), to protect against the financial loss it may incur in case if the reference entity defaults or proclaims bankruptcy or another credit event occurs. If that happens, then, the seller of the protection is obligated to compensate the loss to the buyer of the contract by means of a specified settlement course of action. The buyer of the protection is entitled to protection on a specified notional amount (face value) of the reference entity debt. This view has been supported in the work of Anthropelos (2010). It is to say that the protection buyer is short the underlying credit risk and the protection seller is long the underlying credit risk. (Kolb and Overdahl, 2010)

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Typical CDS transaction (Hull, 2010)

This Figure is a basic common structure (plain vanilla) of the Credit Default Swap. Which only includes one specific reference entity (it could be either entire corporation, sovereign, or specific obligation of loan/debt instrument, bond etc). However, with regard to CDS, Jiang and Zheng (2009) state that if there are two or more reference entities, it is known as Basket CDS. When any of these reference entities defaults, an add-up basket CDS provides the compensation. A first-to-default CDS compensates only when the first default occurs. In relation to a previously negotiated knock-out-option the responsibility of all the other potential defaults can be excluded. A second-to-default CDS provides compensation only when the second default occurs. Following this, an nth-to-default CDS gives compensation only when the nth default occurs. It is also possible to negotiate a combination of defaults as trigger. (Rudolph et al, 2007) After the relevant default has occurred, a settlement is to take place. The payoffs calculation methods are the same as of a regular CDS. The Swaps then comes to an end and no further payments are to be carried out by either party. Moreover, it is more complicated to value the nth-to-default swap compared to normal regular CDS. According to Hull (2010) "It depends on the default correlation between the reference entities in the basket. For example, the higher the default correlation, the lower the CDS spread on a First-to-default swap". (Hull, 2010)

3. Application

3.1 Development of the CDS Market

In 1998 and 1999, the International Swaps and Derivative Association (ISDA) originally created a standard contract credit default swap (CDS), to be traded in the OTC market. Since then, the growth of the CDS market has rapidly increased.

“According to Bank for International Settlements (BIS), in terms of gross market value, the CDS market value increased from USD 133 billion in Dec 2004 to USD 5.7 trillion in Dec 2008 and constitutes the second largest market value after the interest rate contacts”. (European Central Bank, 2009) Other sources say that the outstandings in the credit default market at year 2007 were USD 62.2 trillion, but this number declined to USD 38.6 trillion at December 2008 because of the financial crisis. The outstandings for 2009 are measured at USD 30.4 trillion. For the year 2010 a growth is expected again. (ISDA Market Survey, 2009)

The reason was mainly due to the re-pricing of the credit risk and the increase in the volatility in the market during this period. However, in contrast to figure 2, the second half of the year 2008, there was a significant drop in the CDS market size.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2: CDS Market size (IASD, 2010)

In 2007 and 2008, when the credit turmoil had begun, the first major investment bank to fail during the global financial crisis was Bear Stearns. (Liuling and Mizrach, 2010) The regulatory concerns were fuelled by the downfall of insurance giant AIG. The protection proved very costly to AIG also that the company was bailed out by the U.S. government. AIG had been selling CDS protection excessively, without hedging against the odds that the reference entities might decrease in value. This exposed the insurance giant to huge losses.

In the recent publication Hull (2010) states that during this time, trading of many types of credit derivatives were ceased. However, there was almost no impact on CDS, they continued to trade actively. Also, it was at this point in time (Sept. 2008), when Lehman Brothers were having huge number of CDS contracts with them as a reference entity, during this time they declared bankruptcy. “The recovery rate was only about 8 cents on the dollar, so that the payout to the buyers of protection was equal to about 92% of the notional principle. There were some predictions that some sellers of protection would be unable to pay and that further bankruptcies would occur, but on the settlement day (Oct. 2008) everything went smoothly”. (Hull, 2010)

"Indeed, the CDS market is concentrated around a few large players. In 2008, the five largest CDS dealers were JPMorgan, the Goldman Sachs Group, Morgan Stanley, Deutsche Bank and the Barclays Group". (European Central Bank, 2009)

Abbildung in dieser Leseprobe nicht enthalten

Figure 3: CDS Market - Biggest movers (Bloomberg, 2010)

The chairman of US Security and Exchange Commission (SEC), Christopher Cox (2008) announces that, for CDS trades between financial institutions, regulatory concerns have led to the development of clearing houses, which restricts financial institutions to post margin on their CDS trades, in the similar way that traders post margin on future contracts.

Baskin et al (2010) state that “International momentum is building for stricter oversight of derivatives trading, as a top U.S. regulator recommended new limits on credit-default swaps and European leaders pushed for a ban on speculative bets against government debt following recent financial turmoil in Greece.” The article also reported that, in a speech by Gary Gansler, Commodity Futures Trading Commission chairman, offered his most precise criticism yet of CDS, often blamed for the collapse of AIG Inc. at the time of financial crisis.

However, ISDA (2010) argues that at the time of financial crisis, financial institutions like AIG, Bear Stearns, Lehman Brothers, took the risk of excessive mortgage loans to borrowers. Their risks were heavily dependent on the way they managed mortgage risk and exposure, as well as their collateral and liquidity management. It also included the failure of AIG financial products and the improper rating of mortgage risk and capital adequacy by the rating agencies. Thus, it means that CDS alone are not to be blamed for the downfall, there are many other sources which are the cause but are clearly neglected.

3.2 Pricing and Valuation of CDS

The main idea of a Credit Default Swap (CDS) is to transfer the credit risk of a reference entity from one to another party. In a CDS the party A (protection buyer) pays a periodic insurance premium (“spread”)1 to the counterparty B (protection seller) until the maturity, or until the reference entity defaults. On the other hand the protection buyer receives a payoff from the protection seller only if the reference entity experiences a credit event. From 2009 if applicable, it is to pay an “up-front”. If an index trade is initiated and the quoted price is below the par price then the protection buyer has to make the up-front payment and vice versa. (Kolb and Overdahl, 2010) In the case of a credit event the protection buyer settles the reference asset to the protection seller and therefore the protection seller pays the par value (“physical delivery”). Alternatively, the parties can negotiate “Cash settlement” in which the protection seller has to pay just the par value minus the recovery rate. Additionally, the counterparties can agree to use “Auction settlement”. (Kane and Turnbull, 2003) This method is similar to the cash settlement, unless the recovery rate, so the amount which is deducting from the par value, is determined by an auction where potential buyers can make bid on the referenced asset. This method can be very useful in times, where it is difficult to evaluate the asset. (Kolb and Overdahl, 2010)

[...]


1 Normally, frequency payments are quarterly but payments can be paid monthly or semi-annual as well.

Details

Pages
25
Year
2010
ISBN (eBook)
9783640891597
ISBN (Book)
9783640891498
File size
676 KB
Language
English
Catalog Number
v170187
Institution / College
University of Westminster – Westminster Business School
Grade
67%
Tags
CDS Credit Default Swaps Bloomberg Derivatives Pricing Valuation Financial Derivatives JPMorgan model Bewertung Auspreisung Finanzderivate

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Title: Credit Default Swaps - Pricing, Valuation and Investment Applications