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Group 6: by - Garvit Agarwal Gyan Prakash Karan Gupta Ravikumar Soni Sahil Singla

This document provides an introduction to credit default swaps (CDS). It defines a CDS as a type of insurance against credit risk where the buyer makes periodic payments and receives a payout from the seller if a credit event, such as bankruptcy or failure to pay, occurs. The document outlines the key terms of a CDS including the reference obligation, notional amount, premium, and maturity. It also describes the different types of CDS settlements and some of the models used to value CDS, including structural and reduced form models. The role of CDS in the 2008 financial crisis is briefly discussed. The document concludes with details on India's CDS guidelines.

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Sahil Singla
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52 views

Group 6: by - Garvit Agarwal Gyan Prakash Karan Gupta Ravikumar Soni Sahil Singla

This document provides an introduction to credit default swaps (CDS). It defines a CDS as a type of insurance against credit risk where the buyer makes periodic payments and receives a payout from the seller if a credit event, such as bankruptcy or failure to pay, occurs. The document outlines the key terms of a CDS including the reference obligation, notional amount, premium, and maturity. It also describes the different types of CDS settlements and some of the models used to value CDS, including structural and reduced form models. The role of CDS in the 2008 financial crisis is briefly discussed. The document concludes with details on India's CDS guidelines.

Uploaded by

Sahil Singla
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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INTRODUCTION TO CREDIT DEFAULT SWAP

By

Group 6
Garvit Agarwal Gyan Prakash Karan Gupta Ravikumar Soni Sahil Singla

What are Credit Default Swaps

A kind of insurance against credit risk. Privately negotiated bilateral contract . Reference Obligation, Notional, Premium (Spread), Maturity specified in contract. Buyer of protection makes periodic payments to seller of protection . Generally, seller of protection pays compensation to buyer if a credit event occurs and contract is terminated.

Credit event

Credit event results in payment from protection seller to buyer and termination of contract Most common types of credit events are the following
Bankruptcy Reference entitys insolvency or inability to repay its debt Failure to Pay Occurs when reference entity, after a certain grace period, fails to make payment of principal or interest Restructuring Refers to a change in the terms of debt obligations that are adverse to creditors

If credit event does not occur prior to maturity of contract(typically, 2/5/7/10 years for corporate), protection seller does not make a payment to buyer

Example

CDS Settlement

There are 3 types of CDS settlements: Physical

Settlement

Cash

Settlement

Fixed

value Settlement

Physical Settlement

Protection buyer sells acceptable obligation to protection seller for par. Buyer of protection can choose, within certain limits, what obligation to deliver. Allows buyer to deliver the obligation that is cheapest to deliver.

Cash Settlement

Dealer poll conducted to establish value of reference obligation (for example, x percent of par). Protection seller pays buyer 100 x percent of Notional value. The protection buyer in a 5,000,000 USD CDS, upon the reference entitys filing for bankruptcy protection, would notify the protection seller. A dealer poll would then be conducted and if, for instance, the value of the reference obligation were estimated to be 20% of par, the seller would pay the buyer 4,000,000 USD.

Fixed Value Settlement

A fixed recovery level is decided upon in advance at the time of contract. If on a 5mn USD CDS, the fixed recovery level is 20% then in case of a credit event buyer will receive 4mn USD from the CDS seller.

Key Market Participants

Types of CDS

Single Name CDS


CDS Basket CDS Indices

Valuation Models

Structural Models
Reduced form Models Hybrid Models

Structural Models

Mertons model:
The

source of credit risk is the uncertainty concerning the market value of firm, and the valuing of risky debt Market value of firm compared with Face value of debt Built on insights from option pricing model by Black-Scholes Equity Holder Bond Holder
If At>F If At<F Net Position At-F 0 Max(0,At-f) F At Min(F,At)

Valuation using Merton model

A=B+S
A=Market Value of firms asset S=Market value of equity B=Market value of debt F=Face value of debt (on maturity)

S=P+A-F*e^(-r*T) A-B=P+A-F*e^(-r*T) B=F*e^(-r*T)-P

Defaultable bond is equivalent to holding a risk free bond along with a short put position on the assets of the firm.
Limitations:
Assumption

that default occur on maturity of debt Market value of firm is difficult to estimate

Subsequent models, Black and Cox, allowed default to occur at any time; Surprise events force a firm to file for bankruptcy;

Reduced Form Models

Best suited for highly liquid assets and may not be as accurate in case of low market liquidity; The default event is stochastic with the probability of default linked to variation in the level of interest rate;

CDS and Credit crisis

A low interest rate environment in US resulted in a boom in real estate; ABCP market allowed lenders to package mortgages and sell them through SIVs. The lowered lending criteria and easy offer term increased subprime loans; Borrowers defaulted-ABCP holders also defaulted-ABCP demand dried up-Home prices also declined-More ABCP were in supply reducing their value;

Spillover effect on corporate market as corporate were unable to borrow money; Bankruptcy and recessionary pressure on global economy; CDS were used to insure these ABCP; AIG defaulted on their payment; CDS market came to standstill with little trading occurring

Future of CDS

Taking the market to an exchange based environment and setting up a central clearinghouse as the central counterparty; Standardize of the CDS contracts to avoid any subsequent legal issues and to add transparency to the market; If the instrument is moved to exchange liquidity is expected to increase and market may see boom period;

CDS in India

RBI came up with its guidelines that allowed CDS usage on 25th March 2011. As per the guidelines, foreign institutional investors (FIIs), banks, insurers, NBFCs, listed companies, housing finance companies, provident funds and primary dealers can buy credit protection under the scheme.

Some of the key features of the Draft Guidelines are

Participants in a CDS market have been classified as Users and Market Makers. Users can only buy protection but Market Makers can buy and sell protection. The Draft Guidelines list a number of entities that will be allowed to act as Users and Market Makers. FIIs can act as Users.

NBFCs and primary dealers with a net owned fund of Rs 500 crore will be permitted to act as market makers.

Naked CDS is not permitted. CDS will be allowed only on corporate bonds (excludes loans, CPs). Users cannot enter into an offsetting contract and can sell the underlying bond only with permission of Protection Seller. Restructuring does not qualify as a Credit Event. Creates limits on credit exposures for Users and Market Makers. Mandatory trade reporting within thirty minutes.

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