Hello and welcome back to my YouTube channel, where I upload tutorials on
quantitative finance and derivatives usually in short bite-sized format to
help people understand the important financial topics. Today we're going to
learn all about CDS or credit default swaps why they exist what they're used
for and how they are structured this is video 3 in my series on credit
derivatives if you want to watch the whole series a link to the playlist is
provided above ok so firstly let's answer the question what are credit
default swaps Blythe Masters who you can see on screen right now is widely
credited with creating the modern credit default swap when she worked at JP
Morgan. She became a managing director at the age of 28 the youngest woman to
achieve that status in the firm's history. In 1994 JP Morgan had extended a
4.8 billion dollar credit line to Exxon which faced a threat of 5 billion
dollars in punitive damages for the Exxon Valdez oil spill. A team of JP
Morgan bankers led by Masters then purchased protection against a credit
line to cut the capital which JP Morgan was required to hold against Exxon's
default thus reducing its own risk. Masters idea was based on the idea of a
swap a derivative I've explained in an earlier video instead of swapping bonds
our currency our interest rates her idea was to swap the risk of default in
effect JP Morgan could sell the risk that a borrower won't be able to pay
back they're dead since banking is based on making loans to customers the risk of
default by those customers is a crucial part of the business a product that made
it possible to reduce that risk by selling it to somebody else had the
potential to create a gigantic new market which it did credit default swaps
are legal contracts that provide insurance against the risk of default by
a company or country on its bonds it's a swap agreement that the seller of the
CDS will compensate the buyer in the event of a loan default or other credit
event the CDS buyer makes a series of payments known as the CDS fee or
spread to the seller and in exchange receives a payoff if the loan defaults.
CDS are the most widely traded credit derivatives today. Swap sellers promise
swap buyers a big payment if an entity's bonds are loans default in return they
receive quarterly payments neither needs to hold the underlying
debt when entering into a CDS transaction CDS are similar to other
swaps in that they are valued at zero at inception and later may incur gains or
losses depending on changes in the credit market a company or country can
be the underlying entity on which the contract or derivative is based and
these are called the reference entity in the CDS market a default by the
reference entity is called a credit event the buyer of the insurance has the
right to sell the bonds issued by the reference entity for full face value.
When a credit event occurs the CDS insurance seller has the obligation to
buy the bonds for full face value when a credit event occurs the total face value
is the swaps notional value the buyer makes periodic payments to the seller
until the maturity of the CDS contract or until a credit event occurs typically
quarterly or half yearly settlement can involve physical delivery of the bonds
or a cash settlement a CDS contract typically references the credit
derivatives definitions as published by the International Swaps and Derivatives
Association or ISDA. The confirmation typically specifies a reference entity
that generally although not always has debt outstanding and a reference
obligation usually a non-subordinated corporate bond or government bond. The
life of the contract is specified by the effective date and termination date a CDS
contract usually specifies that a number of different bonds issued by the
reference entity can be delivered in the case of default usually these bonds will
be of similar seniority but they may trade at different prices after default
should this occur the buyer of CDS protection will search for
cheapest to deliver bond which they deliver to the CDS seller in exchange
for the insurance like payout from the CDS contract in the event of the
reference entities default many large financial institutions make markets in
CDS on companies that they may never have lent any money to in the past CDS
market makers will then stand ready to buy or sell protection and earn a spread
between the two prices market makers can hedge their exposures by trading in the
underlying bonds if needed most CDS contracts are five years in duration but
can be traded in other maturities banks are large buyers of credit protection to
hedge their loan books and insurance companies are the biggest sellers of CDS
there are several events that can constitute a credit event and
necessitate a payout on a CDS contract including bankruptcy failure to pay
either coupons or principal payments or restructurings
the legal documents supporting the CDS contracts are very lengthy and potential
investors would be wise to read carefully the definitions of
specifically which corporate actions or events will be classified as credit
events and legally entitled them to the payouts. The CDs spread
refers to the price paid annually for protection on the bonds this can also be
compared to the spread over a risk-free rate at which the underlying reference
entity's bonds trade these should be very close otherwise there would be
arbitrage opportunities typically when a company goes bankrupt there is some
recovery for the bond holders from liquidation of the firm's assets usually
expressed as a percentage of face value and typically estimated to be thirty to
forty percent of the face value of the bonds that's just based on historical
bankruptcy payouts each case of course is unique CDS buyers received the
notional - the recovery in a credit event CDS can be used to hedge a regular
portfolio of bond holdings investors who are long bonds can buy CDS protection so
if the bond was paying out 6% per year if the CDS costs a hundred
basis points or 1% a year they're left with a riskless bond position
effectively a government bond return rate yielding 5% per year for example if
acedia spread or cost of protection is trading a 300 basis points while the
equivalent bond maturity yields 8% and suppose the risk-free rate is 4% the CDS
is trading too cheap and investors could buy the bond buy the CDS protection and
earn an arbitrage profit of 1 percent per year credit market participants have
created indices to track a credit default swap spread movements this can
be a good real-time metric of risk in the bond markets the most followed CDS
index for US credit quality is the CDX in Europe it's the I tracks a key
feature of CDS valuation are the probabilities of default implied in
their pricing these can be backed out of market prices of the CDS and are called
implied probabilities of default the CDs market has been rapidly growing since
the 1990s and CDS are important tools for managing risks however they have
come under significant regulatory scrutiny since banks and insurers held
excessively large CDS positions that went sour in the financial crisis of
2007 2008 a CDS insurance buyer might be paying just one to two percent per
year on a 10 million dollar notional that's approximately the smallest that
anyone would trade ik waiting to just $100,000 to $200,000 but standing to
gain 10 million dollars in a credit event if you pay this for half a year
and then the reference entity default you receive an extremely skewed payoff
profile there for buyers worried considerably about counterparty risk in
the CDs market regulatory pressure has increased on trading CDS in a more
transparent manner the goal is to shift them from opaque OTC transactions on to
exchanges and clearinghouses and to reduce counterparty risk many traders in
the CDS market do not favor and electronically listed and
cleared CDS market since the increased transparency is usually accompanied by
reduced bid-ask spreads for their market making activities in 2009 the dodd-frank
Wall Street Reform and Consumer Protection Act mandated that swaps be
regulated by the Commodity Futures Trading Commission or CFTC it
specifically required a clearinghouse to be set up to trade and fairly priced
swaps in the United States ice clear credit and the CME Group are two central
counterparties for CDS contrary-to swaps tied to indexes regulators haven't
yet pushed most single name credit swaps through central clearing houses instead
they've largely remained bilateral transactions between dealers and clients
requiring higher capital charges under banking regulations this has led
investment banks to withdraw from the market and made trading credit default
swaps more expensive so what are the implications of CDS?
Well some market participants argued that CDS allowed lenders to issue loans
without adequately assessing credit quality since lenders can sell all of
the risks on to other investors and avoid credit evaluation and monitoring
costs the reduction in credit assessment should reduce borrowing costs as
traditionally those evaluation and monitoring costs were passed through to
the borrower's in the form of higher interest rates repackaging and
distributing risk is superior in many ways in that more investors have access
to the returns of a variety of credit issuers than they previously would and
risks are spread out to more investors rather than concentrated within one
financial institution however risk assessment might best be done by a
lender in advance of a loan being made the lender is in a unique position of
access to bond issuers senior management and can request documentation that small
investors would struggle to attain in a world with credit hedging fewer
difficult questions are asked of borrowers and that's a problem
criticisms of CDS critics of the CDS market have claimed that it has been
allowed to become too large without proper regulation and that the CDS
market has no transparency furthermore there have been claims that CDS
exacerbated to 2008 global financial crisis by hastening the demise of
companies such as Lehman Brothers and AIG financial commentators have argued
that insurance markets where neither party has an insurable interest can lead
to suboptimal social behavior there have been cases where bondholders who also
owned large amounts of CDS might aim to push for the company to enter bankruptcy
in order to benefit from the credit event with their CDS many argued that
purchasing insurance when you lack an insurable interest should be regulated
and potentially made illegal CDS can give investors a false sense of security
for example in 2012 the Greek government required bondholders to take a 75% loss
on their holdings CDS were not deemed to have experienced a credit event
because the write down was mandated by Greek law the realization that CDS
provided no protection could have destroyed the CDS market because
borrowers like Greece could intentionally circumvent the CDS payout
however after some delay the International Swaps and Derivatives
Association ruled that these CDS should be considered to have experienced a
credit event and the buyers of protection on Greek debt had to be paid
CDS are usually traded as a five year contract and there's very little
liquidity in off the run CDS traders might buy a CDS contract and after a
few weeks or months wish to sell it they might do this by entering into a new
offsetting 5-year contract which mostly hedges their exposure but we'll leave
some non-overlapping risk when the first contract rolls off and the other still
has some time left on it regulations passed since the G20 2009 Pittsburg
agreement require portfolio compression from certain market participants which
can be achieved through simultaneous Novation cancellation and/or amendment
of multiple contracts this is often facilitated
settlement of a cash out song so how do we price CDs there are two main
approaches to pricing CDS contracts the probability model and the no arbitrage
approach the probability model of pricing CDS takes the present value of
the expected cash flows weighted by the probability of non default the inputs to
this model are the premiums paid the expected recovery rate in the event of a
default the credit curve of the reference entity and the LIBOR curve in
the market for simplicity the initial modeling is done assuming that a default
should it occur happens only on premium payment date in practice if a default
occurs between payment dates the buyer will owe a prorated premium to the CDS
seller but tree can be drawn of all of the possible outcomes are parts of the
investment where at each premium note the reference entity defaults are not
and probabilities are assigned at each juncture to the events a present value
is taken of the probability weighted cash flow outcomes the probabilities of
non default at each juncture are calculated based on the credit spread
curve of the underlying reference entity the no arbitrage approach to pricing CDS
the no arbitrage model assumes that there's no risk-free arbitrage and
assumes no counterparty risk of the protection seller under this model a CD
S is price can be backed out of bond and swap spreads over a risk-free benchmarks
such as LIBOR or US Treasuries suppose that a bond has a spread of 200 basis
points over LIBOR and that the swap spread the spread paid by the fixed rate
payer over the risk-free rate is 60 basis points this means that the CDS
contract should trade at a hundred and forty basis points otherwise in
arbitrage would exist however there are sometimes reasons that in practice this
tight pricing relationship does not hold and in these situations the difference
between the no arbitrage price and the live trading price is called the basis
so that's it for today on CDS all of these videos are based on
my book which is linked to in the description below don't forget to click
on the like button if you found this video helpful and subscribe if you'd
like to see more videos like this tune in tomorrow when we'll learn all about
CDOs see you then bye
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