MMA708-ANALYTICAL FINANCE II COURSE SEMINAR PRESNTATION
BY ARCHIBOLD NANA ACHEAMPONG CREDIT DEFAULT SWAPS BY ARCHIBOLD NANA ACHEAMPONG
SWAP-what is this? A contractual agreement between two parties They agree to make periodic payments to each other according to two different indices Counterparty A makes fixed rate payments to Counterparty B and Counterparty B makes floating rate payments to Counterparty A on the same notional, in a plain vanilla interest rate swap.
CREDIT DEFAULT SWAP(CDS) ? Was originally designed by JP Morgan in 1994. Financial Swap where seller compensates buyer in case of a credit event, such as default. Buyer pays the spread to seller. Receives payoff from seller on defaults. Basically it is the transfer of risk from CDS buyer to seller.
CREDIT DEFAULT SWAP(CDS) ? Is a rapidly growing market. Outstanding CDS amount of $62.2 trillion(by 2007). Contracts are documented under International Swaps and Derivatives Association(ISDA).
CASHFLOWS No Credit Event Credit Event Regular premium payments, usually quarterly, made by buyer to seller, which is specified at the beginning of the transaction. Credit Event Regular premium payments made by buyer up to the time of default. Payoff paid to buyer by seller
HOW IS CDS SETTLED? Physical Settlement Cash settlement Seller delivers payoff and in return takes debt obligation(bond) of reference entity. Cash settlement Seller pays difference between par value and market price of bond.
THE LEHMANN BROTHERS Was the fourth largest investment bank in the US, following Goldman Sachs, Morgan Stanley and Merrill Lynch. Before bankruptcy on September 2008, had approximately $155 billion of outstanding debt. Also had about $400 billion notional value of CDS contracts.
THE LEHMANN BROTHERS-Disaster? Not all CDS contracts could be physically settled since there was inadequate outstanding debt to fulfill all contracts. Necessitated cash settled CDS trades. An auction set price of $8.625 cents on the dollar for Lehman Brothers debt.
THE LEHMANN BROTHERS-Disaster? Sellers of protection on Lehman Brothers CDS pay 91.375 cents, instead of $1. Simply, anyone who held Lehman Brothers bond and had bought protection via CDS contract would receive payoff of 91.375 cents on a dollar.
PRICING CDS Two theories exist Probability model No-arbitrage approach
PROBABILITY MODEL Takes the present value of a series of cash flows weighted by their probabilities of non-default Takes four inputs to price the CDS Issue premium Recovery rate or % of notional repaid in case of default Credit curve for the reference entity XIBOR interest rate curve
PROBABILITY MODEL If there is no default, the CDS price would be the sum of the discounted premium payments Consider a one-year CDS with starting date t0 and four quarterly premium payments occurring at t1, t2, t3 and t4. let CDS nominal= N and issue premium=c Size of quarterly premium = Nc/4 Assume defaults can only occur on one of the payment dates.
Two possible outcomes 1. there are no defaults, hence four premium payments are made and CDS contract survives until maturity. 2. default occurs on the first, second, third or fourth payment date.
PROBABILITY MODEL
PROBABILITY MODEL
PROBABILITY MODEL
Conclusion CDS, as a credit derivative, can yield great returns to investors, as well as can cause investors to lose greatly.
References Röman, Jan, Lecture Notes For Analytical Finance II (2015)