Financial Risk Management: IIT Jodhpur
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Credit Default swap
Overview
• A credit default swap (CDS) can be seen as an insurance against credit risk
• Privately negotiated bilateral contract
• Buyer of protection makes periodic payments to seller of protection
• Reference Obligation, Notional, Premium (“Spread”), Maturity specified in contract
• Generally, seller of protection pays compensation to buyer if a “credit event” occurs and
contract is terminated.
Spread (bps)
Protection buyer Protection seller
Payment in case
of default
Example: 1m notional
Spread: 100bps
Payment: 2500 per quarter
Reference
entity
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Cash flows upon default
Physical settlement vs Cash settlement
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CDS risk
Recap: When we are long a bond, we used PV01 negative convention to express us benefitting from a rally in yields
For a corporate bond, yield could be seen as corresponding sovereign bond yield + credit spread
PV01 is the exposure to interest rate part of the yield
CS01 is the exposure to the credit spread
• Is protection buyer risk similar to selling a bond or buying a bond
• What about protection seller?
• Implications on CS01 signs?
Fixed Rate Payer = Protection Buyer = Short credit risk
Fixed Rate Receiver = Protection Seller = Long credit risk
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Credit Default swap
Evolution of CDS market
Credit Default Swaps Outstanding in billion $
70,000.00
60,000.00
50,000.00
40,000.00
30,000.00
20,000.00
10,000.00
-
1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 1H08 2H08 1H09 2H09 1H10 2H10 1H11 2H11 1H12
Source: ISDA Market Survey (2001~10), DTCC (2010~12)
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CDS can isolate the credit risk
Protection buyer able to transfer credit risk
• Where does it help?
• Reduce credit spread exposure for loans/ bonds
• Adjust credit spread exposure tactically, for example by shorting credit risk
Credit 60 bps
Loan/bond
FX, 6.60 %
Interest yield
Rate
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More concepts related to CDS
Indices and swaptions
• Single name CDS vs Index CDS
• Indices examples:
• CDX NA IG/ CDX NA HY: North America
(CDX IG tracks credit spread for 125 IG North American companies)
• iTRAXX Main/ iTRAXX Xover: Europe
https://cdn.ihsmarkit.com/www/pdf/1221/CDS-Indices-Primer---2021.pdf
• Liquidity much higher in indices. Highest in 5Y tenor.
• Concept of nth to default CDS
• Credit default swaptions: right to receive protection at a fixed spread or sell protection at a fixed
spread
