TERRY BENZSCHAWEL credit default swap (CDS) contract in Exhibit 1. The exhibit shows an example of
is a managing director at Citi
Institutional Clients Group
in New York City, NY.
terry.l.benzschawel@citi.com
ALPER CORLU
A is an agreement to exchange a spec-
ified set of coupon payments in
return for the right to receive the
par face value of a reference obligation after the
particular obligor undergoes a credit event.
a CDS written on $10 million of notional with
reference to firm XYZ. The buyer of protec-
tion makes quarterly payments, the premium leg,
for as long as there is no credit event or until
the maturity of the contract, whichever comes
is an associate at Citi Insti- The parties involved in the contract are a pro- first. The CDS premium, even if trading with
tutional Clients Group tection buyer, who pays the coupons or premiums constant coupon and upfront fee, is often
in New York City, NY.
alper.corlu@citi.com
(usually quarterly), and a protection seller, who expressed as an annual amount in basis points.
receives the premiums, but must pay the buyer Also, contracts from a given firm are commonly
the par value of an eligible security in exchange issued at a number of standard maturities, with
for that security in the event of a default, bank- the most common term being five years. The
ruptcy, or restructuring.1 protection seller agrees to pay the buyer the
In more recent versions of the standard face value of the CDS contract if XYZ under-
CDS contract, the protection buyer makes an goes a credit event and the buyer of protection
upfront payment set by the seller and pays a delivers to the seller the defaulted security or
standard running 100 bp or 500 bp premium its cash equivalent.2
that depends on the riskiness of the reference The advantages of having a liquid credit
obligor. (Even for the new contract, the upfront default swap market are well known. Prior to
cash flow and fixed spread premium can be the development of the CDS market, investors
converted to an effective spread premium). had few options for hedging existing credit
The CDS contract is usually obligor-specific, exposures or entering a short credit position.
referring to either a corporate or sovereign In such cases, investors would have to borrow
entity. The securities that are eligible for bonds in an over-the-counter market, being
delivery to the protection seller in event of subject to poor liquidity and high financing
default, the reference obligations, are typically from costs. In addition, typical fixed-rate corporate
a single class of debt (unsecured bonds, loans, bonds have huge exposure to interest-rate
or subordinated bonds, etc.), but can be asset movements, which is often undesirable for
specific. investors wishing to make pure credit plays.
For most purposes, both the CDS contract The relatively tight bid–ask spreads of CDS
with upfront payment and standard coupon and contracts and, in particular, CDS index prod-
that with no upfront payment and market-based ucts have provided extremely efficient means
coupons can be represented using the diagram for investors to express views on credits of
EXHIBIT 1
Representation of a Typical CDS Contract Prior to April 2009
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Notes: The protection buyer makes regular coupon payments to the protection seller and the contingent exchange of a reference obligation in exchange for payment
of its face value in case of a credit event. More recent contracts have an upfront cash payment to the seller of protection and either a 100 bp or 500 bp running
coupon but can still be represented as in the exhibit.
firms and countries around the world. Furthermore, the CDS are synthetic bonds with implicit funding at LIBOR.
CDS contract has provided the building block for other, To that end, we examine the CDS as asset-swap model
more complicated partitioning of credit exposure via such and its potential limitations. In addition, we suggest a
synthetic products as single-tranche CDOs (S-CDOs), pricing method based on analyses of specified and expected
whereby investors can express a view on credit correla- CDS cash flows that, combined with estimates of phys-
tion with specific risk profiles, and options on CDS, ical default probabilities and recovery values, provides an
whereby investors take positions on credit spread volatility. alternative perspective for evaluating CDS risk and rela-
Despite the wide success of CDS contracts as finan- tive value.
cial instruments, recent turmoil in the credit markets have
exposed vulnerabilities in the CDS market. For example, CASH BOND EQUIVALENT OF CDS
the lack of a central clearinghouse for CDS trades has
revealed systemic and firm-specific weaknesses in the It is nearly axiomatic among CDS investors that a
ability to effectively manage counterparty risk. In addi- CDS contract can be replicated by long and short posi-
tion, conventions for trading CDS have enabled trading tions in cash bonds by the seller and buyer of protection,
practices that, by enabling investors to go short with little respectively, who can borrow the reference obligation in
or no initial investment, have contributed to the unprece- the repo market (Kumar and Mithal [2001] and Kakodkar
dented volatility in cash and synthetic credit markets since et al. [2006]).3 That is, the no-arbitrage argument of the rela-
mid-2007. Furthermore, pressure from buyers of protec- tionship between credit default swaps and corporate bonds
tion via CDS has been blamed for contributing directly, states that one can replicate the premium leg of the CDS
at least in part, to the failure of some firms. Although CDS with a long position in the reference obligation combined
have been widely criticized for their role in the current with a fixed-for-floating interest-rate swap and the payout
credit crisis, an aspect of the CDS market that has been leg with a short position in the reference bond and a repo
largely unrecognized or overlooked is that current methods agreement to borrow that security. For example, Exhibit 2
for pricing and hedging CDS may be inadequate and/or shows the cash flows for each leg of the CDS contract in
problematic. For example, we question some assumptions Exhibit 1 represented as an asset-swap. Clearly, replicating
that underlie the widespread application of risk-neutral each leg of the CDS contract involves several operations
pricing theory to CDS; one of which implies that firms’ by both buyer and seller of protection. The no-arbitrage
EXHIBIT 2
No-Arbitrage Model for CDS Where the Buyer of Protection Is Long a Bond Financed at LIBOR along with an
Interest-Rate Swap and the Protection Seller Is Short the Reference Obligation and Has Borrowed the Bond via Repo
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Note: This representation assumes that all parties can finance all transactions at LIBOR and that there is no cost to the protection seller to repo the reference asset.
model is widely, if only implicitly, assumed by most market assume that the bond is a fixed-rate instrument purchased
participants. The asset-swap and CDS equivalence is at par. To pay for the security, the protection buyer bor-
reflected in the Z-spread,4 the common measure of adjusting rows the par amount times the notional from a bank, call
cash bond spreads for comparison with CDS premiums, and it bank 1, at LIBOR.5 The coupons from the borrowed
by methods for estimating the cash–CDS basis as the spread bond are used for two purposes. First, the obligor enters
to the interest-rate swap curve (Choudhry [2006]). Given into a five-year fixed-for-floating rate swap to generate
the general acceptance of the no-arbitrage argument three-month LIBOR to make quarterly interest payments
between cash bonds and CDS and because we argue that on the loan for the bond. The remainder of the coupon,
this argument has limitations, we consider in detail the no- the amount above the five-year swap rate, is paid out as a
arbitrage model from the perspectives of both buyers and premium to the protection seller. The fact that the buyer
sellers of protection. of the bond must finance the transaction at a rate assumed
to be LIBOR is the reason that the cash versus CDS basis
The Protection Buyer is referenced to the bond’s Z-spread.
As long as the bond pays coupons to the buyer of
A depiction of a five-year CDS contract as an asset- protection, the buyer can finance the bond and pass the
swap between the buyer and seller of protection appears spread premium to the protection seller. If there are no
in Exhibit 2. Consider first the protection buyer who agrees credit events prior to maturity of the CDS and the ref-
to make regular premium payments to the protection seller erence bond, the interest-rate swap expires and the
as long as there is no credit event or until the maturity of bond’s obligor pays the face value to the protection
the CDS, whichever comes first. To replicate this with a buyer, which is used to repay bank 1 for the initial loan.
cash bond, the buyer of protection must purchase a five- However, if the reference obligor triggers a credit event
year bond issued by the reference obligor. For this example, prior to CDS maturity, the buyer of protection is due
the face value of the bond times the notional from the security is then delivered to the counterparty in the orig-
protection seller. The protection buyer can use the payoff inal short sale by the protection seller and the borrowed
to deposit in bank 2 earning LIBOR and use the bond is returned as the repo is unwound whereby the seller
LIBOR proceeds to enter into a floating for fixed-rate of protection pays the lender the loss on the borrowed bond
swap until the remaining maturity of the initial five- (i.e., face value minus recovery). Finally, the fixed-for-floating
year swap. This way, at the maturity of both interest-rate rate swap is offset by a floating–for–fixed swap for the
swap contracts, the net payout will be zero and the buyer remaining time to maturity.
of protection withdraws the deposit in bank 2 and uses
the proceeds to repay the principal on the original loan The CDS–Cash Bond Basis
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from bank 1.
Finally, it should be noted that the demonstration of The previous example is used to explain why, in an
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the no-arbitrage model of the cash bond versus CDS rela- arbitrage-free setting, the break-even CDS premium
tion is not unique. One could devise other combinations should be identical to the asset-swap spread on a bond
of bond purchases and sales, borrowing arrangements, priced at par. Because of this, when investors wish to com-
interest-rate swap agreements, and repurchase agreements pare market risk premiums between CDS and their ref-
to equate cash bonds and CDS. The importance of the pre- erence bonds, they often use the Z-spread, which is a
sent demonstration is that all of these mechanisms involve spread to the LIBOR curve.6 Despite their assumed the-
transactions in markets whose price determinants may oretical equivalence, Z-spreads on cash bonds and their
differ from those of the deliverable obligations, giving rise corresponding default swap spreads are rarely the same, and
to non-credit-related influences on both bond spreads the difference between them is called the basis. For example,
and CDS premiums. Furthermore, these factors may affect Exhibit 3 shows the CDS minus cash bond basis for firms
one side of the buyer/seller relationship and not the other. in the North American investment-grade CDS index
(CDX.NA.IG)7 from December 2005 through April
The Protection Seller 2009. From the inception of the CDX index in 2003, the
basis had typically been 10 bps–20 bps positive (CDX
Consider now the CDS as asset-swap from the per- premium greater than the average of its constituent’s bond
spective of the seller of protection as depicted in the right- Z-spreads), but since 2006, the basis has largely been neg-
hand side of Exhibit 2. Recall that the protection seller ative, with average bond spreads exceeding CDX.NA.IG
receives quarterly payments from the protection buyer premiums by as much as 250 bps.
unless there is a credit event before the maturity of the Given the complexity of the relationship between
CDS. If a credit event is triggered prior to maturity, how- a firm’s reference bond and its CDS, as demonstrated in
ever, the protection seller must pay the protection buyer Exhibit 3, it is not surprising that the basis between cash
the face value of the reference obligation times the notional bonds and CDS is rarely zero. In fact, there are a variety
of the CDS contract. To replicate the payout profile of of market factors, technical details, and implementation
the protection seller in the cash bond market, one can sell frictions that underlie the basis. Some of the well-known
short the reference security, deposit the sale proceeds in factors that influence the basis are as follows:
a bank at LIBOR, and enter into a fixed-for-floating swap.
The fixed leg of the swap is combined with the premium • Method of calculating the basis (e.g., Z-spread,
from the protection buyer to pay the coupon on the bor- I-spread, C-spread)
rowed security. As for the protection buyer, the model • Imbalances between market demand for buying and
assumes that the seller of protection can borrow and lend selling protection
at LIBOR and that none of the securities trade as special • Differences in liquidity premiums for a firm’s cash
in the repo market. and synthetic assets
Assume now that the reference obligor triggers a credit • Impact of “cheapest to deliver” cash asset
event prior to maturity. The protection seller receives the ref- • Funding versus LIBOR
erence security in exchange for the face value of the secu- • Cash reference assets trading away from par value
rity times the notional. The seller makes that payment from • Difference in conventions for accrued interest on
funds deposited in the bank at inception. The reference bonds and CDS premiums
EXHIBIT 3
Historical CDS vs. Cash Bond Basis for Firms in the North American Investment-Grade CDS Index,
December 2005–May 2009
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Q
t Q
CPD = 1 − E exp − ∫ λudu
t 0 (2)
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0
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CPDtQ − CPDtQ−1
pQt ,t −1 = t −1 (3)
∏ i =1
(1 − pQi ,i−1 )
how marginal default and survival probabilities accumu- PVcontingent = ∑ dt ∗ (CPDtQ − CPDtQ−1 ) ∗ (1 − RV ) (5)
t =1
late over time up until default or maturity.
EXHIBIT 5
Cumulative Risk-Neutral Probabilities of Default by Maturity for Various Credit Rating Categories, March 19, 2010
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Finally, setting these two present values equal we Exhibit 5 shows average cumulative risk-neutral
arrive at the following expression for the CDS premium: default probabilities for March 19, 2010, for credit ratings
from AAA to CCC. Risk-neutral default probabilities
4 ∗ ∑ t4=T1 dt * (CPDtQ − CPDtQ−1 ) *(1 − RV ) increase monotonically with maturity for all rating classes.
cT = (6)
∑ 4t =T1 dt * (1− CPDtQ ) As expected, the risk-neutral default probabilities are sig-
nificantly higher as credit quality decreases, being lowest
Much of the modeling effort regarding CDS involves for AAA securities and highest for CCC averages.
determining the term structure of firms’ cumulative risk-
neutral default rates over the life of the contract. Using LIMITATIONS OF THE
Equation (6) and an assumed fraction of face value recov- ASSET-SWAP MODEL OF CDS
ered in default, we can determine the values of cumula-
The traditional no-arbitrage model of the CDS as an
tive default rates, CPDtQ , at each node in the lattice in asset-swap has proved useful for understanding the relation-
Exhibit 4. For example, assume that we have as input a ship between bonds and CDS and has aided the develop-
firm’s market derived CDS spreads for a range of matu- ment of the CDS market. However, large displacements in
rities, e.g., c (T = 0.5), c(T = 1.0 ), ..., c (T = 10). The cum- cash and CDS markets and the 300 bp fluctuation in the
ulative risk-neutral probability of defaults, CPDtQ , can then CDS versus cash bond basis for investment-grade credits in
be obtained from this CDS term structure using a boot- recent years have highlighted limitations of that interpretive
strapping procedure: We first extract CPD0Q.5 using c(0.5) framework. There are other concerns as well. These include:
and then obtain CPD1Q using c(1) and CPDQ0.5 obtained in
the first step. The process continues until we obtain CPDtQ • potential profit or losses from interest-rate swap posi-
for all maturities in the CDS term structure. tions on an asset-swap in the event of default that
would not occur with a CDS;
• failure to account for the cost of risk on the mark- sold the bond short and terminates the repo (or arranges
to-market of positions in the replicating portfolio a reverse repo).8 Assume that, prior to default, swap rates
arising from changes in swap and repo rates as well have increased. Presumably, the price of the fixed-rate
as changes in either party’s credit risk; borrowed bond will have decreased from par value due
• differences in the price of protection for holders of to an overall rise in rates that is independent of its credit
different bonds issued by the same obligor but priced quality. This has a couple of effects. First, the borrower of
in the market at different relationships to par; the bond is now paying a higher rate than LIBOR on the
• consistent positive CDS premiums for AAA rated face value of the bond at its current market price. That
credits, which almost always trade at premiums to is, a new buyer would have to make a lower absolute pay-
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LIBOR, are inconsistent with the asset-swap analogy ment to fund that same bond at that lower price. Fur-
of CDS. thermore, an investor wishing to enter into a CDS contract
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obligor is BBB rated, investors are demanding a 7% yield issued 10 years ago as a 15-year bond at 3.4% and now
and Bond 2 is trading at a discounted price of 85. Finally, has 5 years to maturity. Assume that we bought Bond 2
consider a third bond issued five years ago at par, when on June 15, 2009, at 85, a price well below the par value
borrowing by B rated credits required a coupon of 10.6%. of Bond 1. Since both Bond 1 and Bond 2, while trading
At the current coupon rate of 7%, that bond is now trading at 100 and 85, respectively, will have a 40% recovery of
at 115. face value in default, we might require less default pro-
The risk-neutral cumulative probability of default, tection if we owned Bond 2 than if we owned Bond 1.
CPDtQ , at any maturity for this obligor can be calculated Since CDS are quoted in units of 100 points of face value,
from the obligor’s par yield curve and the U.S. Treasury the need for less protection on Bond 2 should translate
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yield curve. For example, to find the risk-neutral default into fewer CDS contracts for a given notional amount of
probability for the 0.5-year par bond, CPD0Q.5, we assume a bonds than for Bond 1 (or an equal number of contracts
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recovery value (in this case 40% of principal) and solve for at a lower spread premium).
the CPDQ0.5 that equates the cash flows from the 0.5-year par We determine the necessary premium on a CDS for
bond to the value of 100 when discounted by the corre- default protection on 100 face of Bond 2. Let N2 be the
sponding Treasury yield. This process is repeated at regular notional amount of protection that we need to buy to neu-
intervals over the life of the bond in question. The resulting tralize the default risk of Bond 2. To break even in default,
CPDtQ curve for the BBB rated par bonds on June 15, 2009, the buyer of Bond 2 will need to get 45 points per 100 face
appears in Exhibit 7. (i.e., 85 – 40) from the protection seller. In terms of CDS
Within the CDS as asset-swap model, we can use the contract, this should be equal to N2 * (1 – RV/100). Thus,
Q
values for CPDt at various maturities in Exhibit 7 to cal- equating these two values, we have
culate the expected premium of a credit default swap via
Equation (6). The value for the premium obtained using RV
85 − 40 = N 2 ∗ 1 − (7)
U.S. Treasury discount curves is 414 bp per annum. We 100
can approximate this premium as a yield spread to LIBOR
by subtracting the difference between LIBOR and Trea-
sury spot rates on June 15, 2009, a difference of 48 bps. and therefore N2 = 75. Because Bonds 1 and 2 are from
Thus, our estimate of a five-year CDS premium for this the same obligor, we can solve for the premium, c, using
BBB obligor is roughly 366 bps. the same risk-neutral default probabilities and recovery
Now consider Bond 2, the discount bond issued by rate that we used for Bond 1. The resulting value of c is
the same obligor as Bond 1. As mentioned, Bond 2 was 275 bps per annum.
In fact, a simple way to determine the CDS pre-
mium adjustment required for a bond trading away from
EXHIBIT 7 par is to realize that the relative premium between a par
Risk-Neutral Default Probabilities as a Function and non-par bond from the same firm is directly pro-
of Maturity Implied by BBB Bonds and U.S. Treasury portional to their losses in default. That is, for the example
Par Yield Curves, June 15, 2009 of Bonds 1 and 2,
c non-par 85 − RV 45
c par = 100 − RV ⇒ c non-par = 60 × c par = 275 bp (8)
275 bps per annum on Bond 2. Similarly, for Bond 3 from receive $75 from the CDS contract and the recovery
this same obligor, having a 10.6% coupon and trading at value of $40 on the excess 25 points of face not
115 for 100 notional, our analysis suggests that the price delivered into the contract (i.e., $10), thereby recov-
of CDS protection necessary to recover the price in default ering their investment. Investor C, having paid $115
is 458 bps. for 100 face of bond, buys 125 units of CDS pro-
One implication of the foregoing analysis is that, for tection to cover potential loss of investment from
a firm having bonds with different market prices relative default. That is, in default, investor C will receive
to par, the cost of protecting one’s original principal can $125 from the CDS contract but must deliver an
vary significantly, thereby providing potential arbitrage additional 25 units of face at a recovery value of $40
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opportunities. For example, consider three investors, A, B, into the CDS contract at a cost of $10.
and C, where A owns 100 face of Bond 1 in Exhibit 6,
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B owns 100 face of Bond 2, and C owns 100 face of In each scenario, we assume a constant default rate
Bond 3. Investor A will pay $100 for Bond 1, whereas of 0.28% (i.e., the annual historical rate for a BBB credit)
investor B pays only $85 for Bond 2 and investor C pays over the five-year contract term. Exhibit 8 displays the
$115 for Bond 3, assuming that the bonds all trade at internal rates of return (IRRs) for investors A, B, and C
equivalent cash flow yields.9 Suppose each investor buys under two different default scenarios for each of the two
protection on their respective investments to cover poten- hedging scenarios. The first row in Exhibit 8 shows that
tial losses from default and, based on the risk-neutral investor A has an expected IRR of 3.4% under average
default curve in Exhibit 7, assume that the cost of CDS default conditions but a return of only 1.7% if default
protection on 100 face is 3.66% per annum. Now, con- occurs within the first six months. Consider for com-
sider expected returns from two different hedging sce- parison the returns for investor B. In Case 1, buying pro-
narios involving investors A, B, and C. tection on 100 face of CDS, IRRs under historical default
rates for investors A and B are similar. The 0.3% advan-
Case 1: Investors A, B, and C each buy CDS on 100 tage for investor A in Case 1 results from the larger
units of face and pay $3.66 a year until maturity or coupon on the par bond and occurs despite the 15-point
default. advantage in cases of default for investor B. However,
Case 2: Investor A again purchases protection of 100 this advantage for investor A will only result on average.
units of face at $3.66. However, investor B now buys That is, as shown in the far right column of Exhibit 8,
CDS protection on only 75% of the outstanding if the issuer defaults in the first six months, investor B will
face of the bond purchased at $85.10 In default, B will have windfall gains of 39%, owing to the 15 points of
EXHIBIT 8
Returns from Investing in Hypothetical BBB Rated Par and Non-Par Bonds for CDS Protection
Bought for Full Face Value of Bonds or Adjusted for Loss Given Default
Note: The average cumulative five-year default rate for a BBB rated credit is roughly 1.4%.
excess return on the 100 face of CDS protection. the greatest downside risk. More importantly, however,
Exhibit 8 displays IRRs for investor C in Case 1 that these examples reveal clear limitations of the CDS as asset-
are the reverse of those for investor B. That is, for average swap analogy as a general framework for relating bond
default scenarios, investor C performs slightly better than prices to CDS spreads.
investor A (and B), but for early default, investor C suf-
fers a huge loss of 22% on the initial $115 investment. ANALYSIS OF CDS CASH FLOWS
In Case 2, investor B buys CDS protection on only
75% of the outstanding face. Investor B’s annual premium Given the limitations of the CDS as asset-swap
payments therefore will be only $2.75 per unit face per framework described in the previous section, we introduce
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annum per unit of bond face owned. In this case, the a simplified approach to evaluating CDS contracts and
expected IRR for investor B increases to 4.1%, exceeding explore its usefulness for interpreting market data on CDS
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investor A’s IRR of 3.4%. The advantage in expected spreads. In the proposed cash flow framework, we value
returns to investor B under historical default rates results the premium and contingent legs as sums of the discounted
from a combination of relatively low default rates and the values of their expected cash flows under physical mea-
“pull-to-par” at maturity under conditions of no default. sure. For example, Exhibit 9 displays expected cash flows
However, should a default occur in the first six months, from premium and contingent legs of a hypothetical one-
B’s IRR will be only 0.4%, because B, while having his year CDS contract. The values of cpdi are expected cumu-
investment protected, receives little benefit from the pull lative probabilities of actual defaults from time t = 0 to
to par at maturity. The expected IRR for investor C in t = i.11 Notice that the size of the premium payments
Case 2, owner of the premium bond, is lowest at 2.9%, shown on the left-hand side in Exhibit 9 decreases over
owing to the large premium required for 125 points of time, reflecting the fact that their probabilities of payment
CDS protection. However, for an early default, investor decrease as the likelihood of survival decreases over time.
C has a greater IRR than investor A and investor B in Case The contingent payments appear on the right-hand side
2. of Exhibit 9. Over any quarterly interval, expected average
The foregoing analysis has several implications for CDS payouts in default are typically smaller than their
investors in bonds and CDS. First, it is clear that the associated premiums. That is because the larger payouts
risk–reward aspects of CDS protection will differ for are weighted by the probabilities of default. In order to
investors in par and non-par securities from the same issuer. determine the size of the payouts in default one must
In fact, it is not clear which hedging strategy is best for non- assume a recovery value for the reference security. In addi-
par securities as each has its advantages and disadvantages. tion, when valuing the CDS under physical measure we
Buying and hedging discount bonds appears to be the best must also assume a term structure of physical default rates.
overall strategy, whereas investing in premium bonds has For now, we can assume that we know precisely the term
EXHIBIT 9
Example of Quarterly Cash Flows from Premium Leg (left-hand panel) and Contingent Leg (right-hand panel)
Note: L is the Loss Given Default of a Hypothetical One-Year CDS Contract (cash flows not drawn to scale).
structure of physical default rates for all tenors for all credit ordered by ratings and show only slight adjustments with
rating categories. We will consider the implications of changes in the credit cycle. However, breakeven spread
estimating those probabilities in a later section. premiums required by sellers of protection vary by more
To can calculate the present values of the premium than a factor of 10 over the cycle.
and contingent legs under physical measure using similar We can compare market CDS spreads with the
equations as those for risk-neutral pricing in Equations (4) inferred breakeven spreads to determine CDS risk pre-
and (5), except we substitute cpdt for CPDtQ such that miums above the calculated compensation for default. That
is, we use market values of CDS premiums to infer the
4N
cT excess compensation required by sellers of protection, who
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PVpremium = ∑ dt ∗ (1 − cpdt ) ∗ (9) are “long” credit exposure, for their large promised pay-
t =1 4
outs in the event of default. Exhibit 11 displays CDS spreads
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EXHIBIT 10
Estimates of Physical Cumulative Default Probabilities (left-hand side) and Breakeven CDS Premiums
(right-hand side) by Credit Rating and Tenor for Three Different Points in the Credit Cycle
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Note: Breakeven CDS premiums are calculated using Equation (6) and the corresponding default probabilities and a recovery rate in default of 40%.
Source: Citi and Moody’s Investors Service.
premium would result in a greater spread than those shown equivalent hypothesis including difficulties in replicating
for breakeven. However, it would seem difficult to escape a bond synthetically in the CDS and repo markets and
the conclusion that in these times of high liquidity and different implicit CDS premiums for an obligor’s bonds
tight credit spreads, sellers of CDS protection have been of the same maturity but trading at different prices rela-
undercompensated for their risk. tive to par. We also examined an alternative approach to
CDS valuation, one that uses assumed physical default
SUMMARY AND IMPLICATIONS rates as opposed to risk-neutral default rates. The implied
cash flows from each leg under physical measure were
We examined the assumption that credit default then discounted at appropriate risk-free rates and the
swap (CDS) contracts can be replicated by bonds funded resulting breakeven premiums were compared to the
at LIBOR along with an interest-rate swap and a repur- market-implied CDS spreads. Results were presented for
chase agreement. We find limitations of the bond–CDS various rating categories and tenors for several points in
EXHIBIT 11
CDS Spreads and Difference between CDS Spreads and Breakeven Spreads by Rating Category
and Tenor for Three Different Points in the Recent Credit Cycle
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EXHIBIT A1
Cumulative Default Probabilities for Bonds by Rating Category as a Function of Years since Issuance, 1920–2006
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