FIN80018

Derivatives and Risk

Management
Topic 10
Credit Derivatives
Essential Reading:
Hull (2014) Ch. 23
1
Adapted from Hull (2014) Ch. 23

Credit Derivatives

Derivatives where the payoff depends on

the credit quality of a company or
sovereign entity
The market started to grow fast in the late
1990s

Credit Default Swaps (page 504-507)

Buyer of the instrument acquires protection from the

seller against a default by a particular company or
country (the reference entity)
Example: Buyer pays a premium of 90 bps per year
for $100 million of 5-year protection against company
X
Premium is known as the credit default spread. It is
paid for life of contract or until default
If there is a default, the buyer has the right to sell
bonds with a face value of $100 million issued by
company X for $100 million (Several bonds may be
deliverable)
3

CDS Structure

90 bps per year

Default
Protection
Buyer, A

Payoff if there is a default by

reference entity=100(1-R)

Default
Protection
Seller, B

Recovery rate, R, is the ratio of the value of the bond issued

by reference entity immediately after default to the face value
of the bond
4

Other Details of CDSs

Payments are usually made quarterly in arrears

In the event of default there is a final accrual
payment by the buyer
Settlement can be specified as delivery of the
bonds or (more usually) a cash equivalent
amount
Suppose payments are made quarterly in the
example just considered. What are the cash
flows if there is a default after 3 years and 1
month and recovery rate is 40%?
5

Attractions of the CDS Market

Allows credit risks to be traded in the

same way as market risks
Can be used to transfer credit risks
to a third party
Can be used to diversify credit risks

CDSs and Bonds

A 5-year bond plus a 5-year CDS produces

a portfolio that is (approximately) risk-free
This shows that bond yield spreads should
be close to CDS spreads
The CDS-bond basis is the excess of CDS
spreads over the corresponding bond yield
spreads. (Negative during the credit crisis)

The Payoff

Usually there are a number of bonds that

can be delivered in the event of a default
The protection buyer can choose to deliver
the bond with the lowest price
In practice an auction process is usually
used to determine a cash payoff

Attractions of the CDS Market

Allows credit risks to be traded in the

same way as market risks
Can be used to transfer credit risks to a
third party
Can be used to diversify credit risks

CDS Spreads and Bond Yields

(See page 506-507)

Portfolio consisting of a 5-year par yield

corporate bond that provides a yield of 6% and a
long position in a 5-year CDS costing 100 basis
points per year is (approximately) a long position
in a riskless instrument paying 5% per year
This shows that CDS spreads should be
approximately the same as bond yield spreads

10

Valuation

Suppose that conditional on no earlier default a

reference entity has a (risk-neutral) probability of
default of 2% in each of the next 5 years
Assume payments are made annually in arrears,
that defaults always happen half way through a
year, and that the expected recovery rate is 40%
Suppose that the breakeven CDS rate is s per
dollar of notional principal

11

 Calculate

the probability of default survival

PV of Survival
PV of default
PV payoff
AT break even]PV of survival + PV of
default= PV of payoff

12

Excel for Practice

Fundamentals of Futures and Options Markets, 8th Ed, Ch 23, Copyright John C. Hull 2013

13

Unconditional Default and Survival

Probabilities default prob 2%(Table
23.2, page 508)

Time
(years)

Default
Probability

Survival
Probability

0.0200

0.9800

(0.98*2)
0.0196

0.9604 (10.196)

0.0192

0.9412

0.0188

0.9224

0.0184

0.9039
14

Calculation of PV of Payments s is expected payment for one

dollar of principle
Table 23.3, page 509 (Principal=$1)

Time
(yrs)

Survival
Prob

Expected
Paymt

Discount
Factor

PV of
Exp Pmt

0.9800

0.9800s

0.9512

0.9322s

0.9604

0.9604s

0.9048

0.8690s

0.9412

0.9412s

0.8607

0.8101s

0.9224

0.9224s

0.8187

0.7552s

0.9039

0.9039s

0.7788

0.7040s

Total

4.0704s
15

Present Value of Expected Payoff

Table 23.4, page 509 (Principal = $1)
Time
(yrs)

Default Rec. Expected Discount PV of Exp.

Probab. Rate Payoff
Factor
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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PV of Accrual Payment made in event

of a Default. Table 23.5, page 510 (Principal=$1)
Time

Default
Prob

Expected
Accr Pmt

Disc
Factor

PV of Pmt

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
17

Putting it all together

PV of expected payments is
4.0704s+0.0426s=4.1130s
The breakeven CDS spread is given by
4.1130s = 0.0511 or s = 0.0124 (124 bp)
The value of a swap with a CDS spread of
150bp would be
4.11300.0150 0.0511 or 0.0106
times the principal.
18

Other Credit Derivatives

Binary CDS
First-to-default Basket CDS
Total return swap
Credit default option
Collateralized debt obligation

19

First to Default Basket CDS (page

512)

Similar to a regular CDS except that several

reference entities are specified and there is a
payoff when the first one defaults
This depends on default correlation
Second, third, and nth to default deals are
defined similarly

20

Credit Indices

CDX NA IG tracks the average CDS

spread for a portfolio of 125 investment
grade (rated BBB or above) North
American companies
iTraxx Europe tracks the average CDS
spread for a portfolio of 125 investment
grade European companies
21

Asset Backed Securities (ABSs)

Securities created from a portfolio of loans, bonds, credit

card receivables, mortgages, auto loans, aircraft leases,
music royalties, etc
Usually the income from the assets is tranched
A waterfall defines how income is first used to pay the
promised return to the senior tranche, then to the next
most senior tranche, and so on.

22

Collateralized Debt Obligations

(Page 516-519)

A cash CDO is an ABS where the underlying assets are

debt obligations
A synthetic CDO involves forming a similar structure with
short CDS contracts
In a synthetic CDO most junior tranche bears losses first.
After it has been wiped out, the second most junior
tranche bears losses, and so on

23

Synthetic CDO Structure (Figure 23.3)

Short CDS 1
Short CDS 2
Short CDS 3

Tranche 1
$75 million
Spread = 8bp

Tranche 2
$10 million
Spread = 40bp

SPV
Short CDS n
Total Principal
=$100 million
Average spread
= 100bp

Tranche 3
$10 million
Spread = 300bp
Tranche 4
$5 million
Spread = 800bp
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