Credit & Derivatives

Credit Default Swap A Primer

Girish V S

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The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage. - Allan Greenspan

A CDS is like an insurance policy. In an insurance policy, the insurance firm pays the loss amount to the insured party

Come October 24, Indian corporate houses and banks will have a new tool in their hands to manage credit risk the Credit Default Swap or CDS. From the highs of 2007, when the outstanding notional amount on CDS was around 63 Trillion USD, it has come down to around USD 27 Trillion as of May 20th, 15.4 trillion single name, 10.26 of index and 2.27 tranche. Some experts have blamed the CDS for the global financial crisis. The Banking & Finance World brings you an overview of the CDS. What is a CDS? Markit, the leading provider of CDS market data defines CDS as a credit derivative transaction in which two parties enter into an agreement, whereby one party (the Protection Buyer) pays the other party (the Protection Seller) periodic payments for the specified life of the agreement. The Protection Seller makes no payment unless a credit event relating to a predetermined reference asset occurs. If such an event occurs, it triggers the Protection Sellers settlement obligation, which can be either cash or physical. India will follow physical settlement. A CDS is like an insurance policy. In an insurance policy, the insurance firm pays the loss amount to the insured party. Similarly, the buyer of the CDS the bank or institution that has invested in a corporate bond issue seeks to mitigate the losses it may suffer on account of a default by the bond issuer. Credit default swaps allow one party to buy protection from another

party for losses that might be incurred as a result of default by a specified reference instrument a bond issue in India. The buyer of protection pays a premium to the seller, and the seller of protection agrees to compensate the buyer for losses incurred upon the occurrence of any one of several specified credit events. Thus CDS offers the buyer a chance to transfer the credit risk of financial assets to the seller without actually transferring ownership of the assets themselves. Example: Suppose State Bank of India invests in INR 100 crore bond issued by Essar Steel. SBI wishes to hedge losses that may arise from a default of Essar Steel. SBI can buy a credit default swap from,say, J P Morgan. SBI will pay fixed periodic payments to J P Morgan, in exchange for default protection. The Jargon Protection Buyer is the bank or financial institution which has invested in a corporate either a bond or as credit and who wishes to hedge the credit risk. The buyer pays the premium. SBI in our example. Protection Seller is the Bank or Financial Institution which is willing to offer the insurance against losses sought by the buyer. The seller receives the premium. JP Morgan in our example. Reference Credit the specific loan or bond for which protection is sought. The Essar Bond in our example. Credit Event or Trigger event The
June 2011

THE BANKING & FINANCIAL WORLD

Credit & Derivatives

event that will cause the buyer of protection to invoke the claim against the seller. For example, a bank may have specified that its corporate customer should not issue further debt. In case the corporate should issue further debt, it becomes a trigger event and the bank will invoke the CDS protection can ask the seller for the money. The trigger event is usually bilaterally determined. ISDA documentation provides for six types of trigger events Bankruptcy Failure to pay Restructuring Repudiation/moratorium Obligation Acceleration Obligation default However the market in USA generally looks at only the first three. Notional Amount - refers to the par value of credit protection bought or sold, INR 100 Crores in our example. The premium payment calculations for each payment period and the recovery amounts in the event of a default depends on the notional amount. CDS Spread Spread is also called a premium. This is the amount paid by the Protection Buyer to the Protection Seller. The spread is denominated in basis points and is paid quarterly. For example if the spread for Essar is 100 basis points, SBI will pay J P Morgan 100 basis points multiplied by INR 100 Crores (the notional of the trade) annually. The amount will be paid in four equal tranches in advance. Credit Spread Curve is the curve generated by the credit spread for a unique reference entity/tier/currency/docclause combination over different tenors. Recovery Rate is the estimated percentage of par value that bondholders will receive after a credit event. In the US for a AAA bond it was 40%. Reference Entity is the legal entity that is the subject of a CDS contract. The reference entity can be the issuer or the guarantor of the debt. In our example it is Essar Steel. Reference Obligation is the specific bond issue that is referenced in the CDS contract Settlement is the exchange of cash for the reference obligation in case of a credit event. RBI has specified that settlement should physical delivery. The substitution of cash instead of physical delivery was the cause of the large speculative positions in the global CDS market. Tenor Refers to the duration of a CDS contract. Tier refers to level of debt in the capital structure of the reference entities. There can be four tiers, each representing a different level of seniority in liquidation. Each tier will have a different CDS protection. Senior Subordinated Junior Preferred Upfront Refers to the initial lump sum payment made when entering a CDS transaction. Upfront payments are made when the credit quality of the reference entity is poor. Use of CDS CDS can be used by protection buyers to hedge their credit exposure and by protection sellers to participate in credit markets, without actually owning assets. The protection buyer can transfer credit risk on an entity without transferring the underlying instrument, reap regulatory benefit in terms of lower capital charge, seek reduction of specific concentrations in credit portfolio and go short on credit risk. The protection seller will be able to diversify his portfolio, create exposure to a particular credit, have access to an asset which may not otherwise be available and increase the yield on his portfolio. Apart from the above, CDS help Banks to transfer risk to other risk takers, so banks can make more loans. Distribute risk widely throughout the system and prevent concentrations of risk. Provide important information about credit conditions, helping bankers and policymakers to supervise traditional banking activities. Serve signaling functionCDS prices are reported to produce better and more timely information. Risks in CDS In a CDS transaction, the risks assumed by the protection buyer and protection seller are not symmetrical. The protection buyer gives up the risk of default by the reference entity, but takes on the risk of simultaneous default by both the protection seller and the reference credit. The protection seller takes on the default risk of the reference entity.
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CDS can be used by protection buyers to hedge their credit exposure and by protection sellers to participate in credit markets, without actually owning assets

June 2011

THE BANKING & FINANCIAL WORLD