Derivatives (ECONM3017)

Lecture Five: Swaps II

(Credit Derivatives)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

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Table of contents

1 Learning Outcomes

2 General Information

3 Credit Default Swaps

4 Collateralised Debt Obligations

5 Miscellanea

6 Summary

7 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Explain the key features of a credit derivative.
2 Differentiate between various types of credit derivatives.
3 Understand the cash flows associated with credit derivatives.
4 Understand the main functions of credit derivatives.
5 Value credit derivatives.

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General Information

Features
The payoffs to credit derivatives depend on the credit worthiness of a
company (or companies).
The main function of credit derivatives is to allow companies to trade
credit risk (as opposed to market risk).
Types
Single-name credit derivatives: payoffs depend on one company (or
country), e.g., credit default swap (CDS).
Multi-name credit derivatives: payoffs depend on many companies (or
countries), e.g., collateralised debt obligation (CDO).

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Credit Default Swaps

Some Definitions/Terminology
Provides insurance against the risk of a company defaulting.
The company is referred to as the reference entity.
The default by the company is referred to as a credit event.
Cash Flows
Buyer of the CDS makes regular payments (every quarter, half year, or
year) until the end of the life of the CDS or until a credit event occurs.
If a credit event occurs then the buyer obtains the right to sell bonds
issued by the company at face value.

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Credit Default Swaps (cont.)

Cash Flows (cont.)

Example
Suppose that two parties enter into a 5-year credit default swap on March 20,
2015. Assume that the notional principle is $100 million and the buyer agrees
to pay 90 basis points annually (referred to as the credit spread) for protection
against default by the reference entity.
The above cash flows can be represented diagrammatically as follows:
90 basis points per year
-
Default protection buyer  Default protection seller
payment if default
Note 1: If a credit event occurs then the buyer has the right to sell bonds issued
by the reference entity for $100 million.
Note 2: If cash settlement is specified in the contract then a cash payment
equal to the difference between the market value of the bonds and $100 million
will be paid by the seller to the buyer.

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Credit Default Swaps (cont.)

Valuation
CDS spreads on individual reference entities can be calculated from default
probabilities.

Example
Consider a 5-year CDS, in which the probability of a reference entity defaulting
during a year (conditional on no earlier default) is 2%. Furthermore, assume
that defaults happen halfway through the year, and that payments are made at
the end of each year. The risk-free rate is 5% per annum with continuous
compounding and the recovery rate (the relative value of the bonds after
default) is 40%.
The calculation can be divided into four parts.

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Credit Default Swaps (cont.)

Valuation (cont.)

Example (cont.)
Part One: Calculating survival probabilities
The probability of default during the first year is 0.02, and the probability that
the reference entity will survive until the end of the first year is 0.98.
The probability of default during the second year is 0.98 × 0.02 = 0.0196, and
the probability of survival is 0.98 × 0.98 = 0.9604.
The probability of default during the third year is 0.98 × 0.98 × 0.02 = 0.0192,
and the probability of survival is 0.98 × 0.98 × 0.98 = 0.9412.
The process continues until default and survival probabilities for each year are
obtained.

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Credit Default Swaps (cont.)

Valuation (cont.)

Example (cont.)
Part Two: Calculating the present value of expected payments
Assume that payments are made at the rate of s per year and the notional
principal is $1.
To calculate the total present value of payments we follow the table below:
Time Pr(Surv.) E(Payment) D.F. PV(E(Payment))
1 0.9800 0.9800s 0.9512 0.9322s
2 0.9604 0.9604s 0.9048 0.8690s
3 0.9412 0.9412s 0.8607 0.8101s
4 0.9224 0.9224s 0.8187 0.7552s
5 0.9039 0.9039s 0.7788 0.7040s
Total 4.0704s

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Credit Default Swaps (cont.)

Valuation (cont.)

Example (cont.)
Part Three: Calculating the present value of the expected payoff
To calculate the present value of the payoff we follow the table below:
Time Pr(Def.) Rec. Rate E(Payoff) D.F. PV(E(Payoff))
0.5 0.0200 0.4 0.0120 0.9753 0.0117
1.5 0.0196 0.4 0.0118 0.9277 0.0109
2.5 0.0192 0.4 0.0115 0.8825 0.0102
3.5 0.0188 0.4 0.0113 0.8395 0.0095
4.5 0.0184 0.4 0.0111 0.7985 0.0088
Total 0.0511

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Credit Default Swaps (cont.)

Valuation (cont.)

Example (cont.)
Part Four: Calculating the accrual payment in the event of default
As payments are made in arrears, a final accrual payment must be made by the
buyer in the event of default. As the default event occurs halfway through the
year an accrual payment covering half a year is required – that is, 0.5s.
To calculate the present value of the expected accrual payments we follow the
table below:
Time Pr(Def.) E(Acc. Payment) D.F. PV(E(Acc Payment))
0.5 0.0200 0.0100s 0.9753 0.0097s
1.5 0.0196 0.0098s 0.9277 0.0091s
2.5 0.0192 0.0096s 0.8825 0.0085s
3.5 0.0188 0.0094s 0.8395 0.0079s
4.5 0.0184 0.0092s 0.7985 0.0074s
Total 0.0426s

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Credit Default Swaps (cont.)

Valuation (cont.)

Example (cont.)
From the previous calculations, the present value of the expected payments will
be 4.0704s + 0.0426s = 4.1130s.
The present value of the expected payoff is 0.0511.
Equating the two,
4.1130s = 0.0511,
and solving for s, gives s = 0.0124.
Thus, the CDS spread for the 5-year deal considered above is 0.0124 times the
principal, or 124 basis points per year.

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Collateralised Debt Obligations

Basic Details
A collateralised debt obligation (CDO) is a type of asset-backed
security (ABS, i.e., a security created from a portfolio of loans, bonds,
mortgages etc.).
The assets being securitised are bonds issued by corporations (or
countries).
The CDO creator acquires a portfolio of bonds.
These are passed on to a special purpose vehicle (SPV), also known as
a conduit.
The income from the bonds is passed to a series of tranches.
By prioritising the income to the tranches (senior, mezzanine, junior,
etc.), different credit-rated instruments can be created (AAA, BBB,
not rated, etc.).
The objective of the creator is to sell the tranches to investors for more
than the amount paid for the bonds.

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Miscellanea

The 2007 Credit Crunch

Between 2000 and 2006 mortgage lenders in the U.S. relaxed standards
(liar loans, NINJAs, ARMs).
Interest rates were low.
Demand for mortgages increased fast.
Mortgages were securitized using ABSs and ABS CDOs.
In 2007 the bubble burst.
House prices started decreasing. Defaults and foreclosures, increased
fast.
The spread of the crash (contagion) across many countries was due to
widespread ownership of the tranches of ABSs and ABS CDOs.

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Miscellanea (cont.)

Other Credit Derivatives

Binary CDS
First-to-default Basket CDS
Total Return Swap
Credit Default Option

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Summary

Basics
Credit derivative types.
Credit Default Swaps
Cash flows, function, and valuation.
Collateralised Debt Obligations
The basic definition only.
Miscellanea
The 2007 credit crunch, and other types of swaps.

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Reading

Essential Reading
Chapters 8, 24, and 25, Hull (2015).
Further Reading
Gorton, G., 2008, The subprime panic, European Financial Management.

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