16-12-2020

Credit Derivatives

Sankarshan Basu
Professor of Finance
Indian Institute of Management
Bangalore

Credit Derivatives
• Credit derivatives are contracts where the payoff
depends on the creditworthiness of one or more
companies or countries.
• Credit derivatives allow companies to trade credit risks
i.e. acquire credit risk to earn return or remove credit risk
by hedging.
• Credit derivatives are “single name” or “multiname”.
• “Credit default swap” is the most popular single name
credit derivative.
• “Collateralized Debt Obligation (CDO)” is the most
popular multiname credit derivative.

Credit Derivatives
• Some important products are:
- Total return swap
- Credit default products:
- Credit default swap
- Basket CDS
- CDS forwards and options
- Credit spread products:
- Credit spread option
- Credit spread forward
- Synthetic CDO

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Total Return Swap

• Agreement to exchange total return on a
portfolio of reference obligations for
periodic floating payments.
• At the end there is a payment reflecting
the change in value of the assets
Total return on reference obligations

Total Return Total Return

Receiver Payer
Periodic floating payments

Total Return Swap

• A portfolio manager typically uses a total
return swap to increase credit exposure.
• It can also be used as financing tools by
managers who want an investment in the
assets.
• Total return receiver is exposed to both
credit risk and interest rate risk.

Total Return Swap - example

• A portfolio manager believes that the credit spread on a
$10 million 10-year 8.5% coupon par bond of a company
will decline over the next year since the financial health
of the company will improve. Current spread over
Treasury is 300 bps (10-yr. Treasury yield is 5.5%).
• The manager enters into a total return swap on this bond
as total return receiver at 6-month Treasury rate plus
140 bps for 1 year with semi-annual payments.
• Suppose the credit spread on the bond declines to 200
bps after 1 year.
• Suppose the Treasury rates move the following way:
- 6-month Treasury rate is 4.6% initially
- 6-month Treasury rate is 5.6% after 6 months
- 9-year Treasury rate is 7.0% after 1 year

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Total Return Swap - example

• The floating rates for the total return receiver are 6%
after 6 months and 7% after 1 year and bond yield after
1 year is 9%. The value of the bond after 1 year will be
96.96.
• Payments by the total return receiver:
- first swap payment after 6 months = $300,000
- second swap payment after 1 year = $350,000
Total payment = $650,000
• Receipts by the total return receiver:
- coupon receipt = $850,000
- capital loss = $304,000 ($1 million - $969,600)
Total receipt = $546,000
• If the bond yield is 8.5% after 1 year with other rates
remaining the same, he will earn a net profit of $200,000.

Credit Default Swap

• Credit default swaps are used to shift
credit exposure to a credit protection
seller.
• CDS structure is as follows:
Contingent payment
if credit event occurs
Protection Buyer Protection Seller

Swap premium

Reference Obligation

Credit Default Swap - Terminology

• Protection buyer – entity hedging credit risk
• Protection seller – entity providing protection by taking
exposure to credit risks
• Reference entity – issuer of the debt instrument
• Reference obligation – particular issue for which the
protection is sought
• Premium leg – payments made by the protection buyer
• Protection leg – contingent payments made by the
protection seller if credit event occurs
• Single name CDS – only one reference obligation
• Basket default swap – a portfolio of reference obligations
• Credit default swap index – the underlying is a
standardized basket of reference entities

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Credit Default Swap - Terminology

• CDS spread (bid and offer) – market makers quote both
the spreads.
- A 250 bps bid spread means that the market maker is
ready to buy protection by paying 2.5% of the principal
per year.
- A 260 bps offer spread means that the market maker is
ready to sell protection for 2.6% of the principal per year.
• CDS settlement
- Suppose two parties enter into 5-year CDS on March 1,
2009 on $100 million principal and 90 bps annual swap
payment.
- If there is no default, buyer receives no payoff and pays
$900,000 at the end of each year for 5 years.

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Credit Default Swap - Terminology

- Suppose, there is a credit event on June 1, 2012.
- If contract specifies physical settlement, buyer sells the
bonds to the seller and receives $100 million for $100
million. Buyer also pays the accrued premium for the
period March 1 to June 1, 2012 (i.e. $225,000 approx.)
- If contract specifies cash settlement, an independent
valuer values the reference obligation. Suppose, the
value is $35 million. The seller then pays the balance
$65 million to the buyer. Buyer also pays the accrued
premium for the period March 1 to June 1, 2012 (i.e.
$225,000 approx.)
• Swap payments are generally made in arrears.

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Credit Default Swap - Terminology

• Some credit events (as per ISDA)
- bankruptcy
- failure to pay – reference entity fails to make one or
more payments when due.
- restructuring – when due to restructuring of the
reference entity, new obligation terms are less attractive
to the debt holder than the original terms.
- downgrade
- credit event upon merger if obligation terms are less
attractive

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Basket Credit Default Swap

• In a basket CDS, there are a number of
reference entities. In Nth.-to-default CDS, the
protection seller makes a payment to the
protection buyer only after there has been a
default for the Nth. reference entity and no
payment for the default of the first (N-1)
reference entities. The swap then terminates
and there are no further payments by either
party.
• There are first-to-default or second-to-default
basket CDS. Typically there are 3 to 5 reference
entities.

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Basket Credit Default Swap

• In a subordinate basket CDS, there is a
maximum payout for each reference entity
and a maximum aggregate payout over
the tenor of the swap for the basket of
reference entities.
• In a senior basket CDS, there is a
maximum payout for each reference entity
but the payout is not triggered until after a
specified dollar threshold is reached.

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Basket Credit Default Swap

• Suppose there are five reference entities and
losses on default over the tenor of the basket
CDS are as follows:
- loss on default of the 1st. entity: $6 million
- loss on default of the 2nd. entity: $10 million
- loss on default of the 3rd. entity: $16 million
- loss on default of the 4th. entity: $12 million
- loss on default of the 5th. entity: $15 million
• In 2nd.-to-default swap, no payment will be made
for the first default and CDS will be settled on
the second default.

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Basket Credit Default Swap

• In a subordinate default swap with max. $10
million payout for a reference entity with
aggregate of $15 million payout, protection seller
pays $6 million on the first default and $9 million
on the second default and the swap terminates.
• In a senior default swap with max. $10 million
payout for a reference entity but after $40 million
default losses (threshold), there will be no
payment for the first four defaults since total
payable loss is $36 million (6+10+10+10). The
payout on the fifth default will be $6 million
(36+10-40) only and the swap terminates.

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CDS Forwards and Options

• A forward CDS is the obligation to buy or sell a particular
CDS on a particular reference entity at a particular future
time, T. If the reference entity defaults before time T, the
forward contract ceases to exist.
• A CDS option is an option to buy (call) or sell (put) a
particular CDS on a particular reference entity at a
particular future time, T. Ex. – A trader can negotiate the
right to buy a 5-year CDS on a company starting in 1
year for 280 bps. The premium is paid upfront. The
option will be exercised if the 5-year CDS spread is more
than 280 bps after 1 year. If the reference entity defaults
before time T, the option contract usually ceases to exist.

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Credit Spread Option

• A credit spread option is an option whose payoff

depends on the change in credit spread for an
underlying reference obligation.
• The underlying can be:
- a reference obligation with a fixed credit spread
- the level of the credit spread for a reference
obligation.
• The exercise style can be European, American
or Bermudan (some specific dates).

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Credit Spread Option on a Reference

Obligation with a Fixed Credit Spread
• Payoff on call option = max (0, Market price of the
reference obligation at maturity – Price of the reference
obligation at maturity at strike yield)
• Payoff on put option = max (0, Price of the reference
obligation at maturity at strike yield - Market price of the
reference obligation at maturity)
• Suppose a reference obligation is an 8% 10-year credit-
risky bond selling at par (YTM 8%). Benchmark is US T-
Bond selling to yield 6%. So, current credit spread is 200
bps.
• An option is written for 6 months with 300 bps strike
credit spread.

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Credit Spread Option on a Reference

Obligation with a Fixed Credit Spread
• Suppose that after 6 months 9.5-year Treasury rate is
6.5% and the reference obligation is trading at 82.59
(11% YTM).
• Market price of the ref. obligation at maturity = 82.59
• Price of the reference obligation at maturity at strike yield
= Price of a 9.5-year 8% coupon bond selling to yield
9.5% = 90.75
• In this case the credit spread call option will be worthless
but the put option will be exercised with payoff = 8.16
• The payoff in these options depend both on interest rate
risk and credit spread risk.
• An investor can buy credit spread put option on a
reference obligation with a fixed credit spread as
protection against credit spread risk.

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Credit Spread Option with Credit Spread on

a Reference Obligation as the underlying
• Credit spread call option payoff = (Credit spread at
exercise – Strike credit spread)*Notional amount*Risk
factor
• Credit spread put option payoff = (Strike credit spread -
Credit spread at exercise)*Notional amount*Risk factor
• Credit spreads should be in decimal form.
• Risk factor
= Sensitivity of reference obligation to changes in the
credit spread
= % price change for 1 bps in rates * 10,000

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Credit Spread Option with Credit Spread on

a Reference Obligation as the underlying
• Suppose a manger has bought an 1-year call option on a
$20 million notional principal bond with risk factor of 6.65
at strike credit spread of 178 bps at a premium of
$250,000 since she believes that the credit spread will
increase.
• Suppose the credit spread at maturity is 250 bps.
• The call option will be exercised since the credit spread
at maturity is higher than the strike spread.

• The payoff on the call option

= (0.025 – 0.0178) * $20,000,000 * 6.65 = $957,600
• The net profit for the manager = $957,600 - $250,000 =
$707,600

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Credit Spread Forward

• A forward contract requiring an exchange of
payments at the settlement date based on a
credit spread.
• The underlying can be the a reference obligation
with a fixed credit spread or the level of the
credit spread for a reference obligation.
• Payoff on a credit spread forward contract at
settlement with credit spread as the underlying
= (Credit spread at settlement date – Contract
credit spread) * Notional amount * Risk factor

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Synthetic CDO
• A long position in a corporate bond has
essentially the same credit risk as a short
position in the corresponding CDS.
• Cash CDO is formed out of a portfolio of
bonds.
• A synthetic CDO is created with a portfolio
of short positions in credit default swaps.
• The credit risks are passed on to the
tranches.

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Synthetic CDO - example

• Suppose that the notional principal in a portfolio of CDS
is $100 million and that there are three tranches. The
design of the tranches are as follows:
- Tranche 1: responsible for the first $5 million losses
and earns 15% on the remaining Tranche 1 principal as
compensation.
- Tranche 2: responsible for the next $20 million losses
and earns 100 bps on the remaining Tranche 2 principal
as compensation.
- Tranche 3: responsible for all the losses in excess of
$25 million and earns 10 bps on the remaining Tranche
3 principal as compensation.

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Synthetic CDO Structure

Tranche 1: 5% of principal
Responsible for first
Short position in $5 million losses
CDS 1 Earns 1500 bps

CDS 2
CDS 3
Tranche 2: 20% of principal
Responsible for next
Trust $20 million losses


Earns 100 bps

CDS n Tranche 3: 75% of principal

Responsible for all losses
in excess of $25 million
Earns 10bps

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Synthetic CDO - example

• The principals for the tranches 1, 2 and 3 are $5 million,
$20 million and $75 million.
• Initially Tranche 1 earns 15% on $5 million.
• Suppose after 6 months, there is a loss of $1 million.
Tranche 1 pays this amount and continues to earn 15%
on the remaining $4 million principal.
• When losses are say $7 million,
- Tranche 1 has already paid $5 million and has been
wiped out and
- Tranche 2 has paid $2 million and continues to earn
1% on the remaining principal of $18 million.
- Tranche 3 continues to earn 0.1% on the remaining
principal of $75 million.

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Synthetic CDO
• A synthetic CDO tranche may be either funded or
unfunded. Under the swap agreements, the CDO could
have to pay up to a certain amount of money in the event
of a credit event on the reference obligations in the
CDO's reference portfolio. Some of this credit exposure
is funded at the time of investment by the investors in
funded tranches. Typically, the junior tranches that face
the greatest risk of experiencing a loss have to fund at
closing.
• Until a credit event occurs, the proceeds provided by the
funded tranches are often invested in high-quality, liquid
assets The return from these investments plus the
premium from the swap counterparty provide the cash
flow stream to pay interest to the funded tranches.

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Synthetic CDO
• When a credit event occurs and a payout to the swap
counterparty is required, the required payment is made
from the reserve account that holds the liquid
investments. In contrast, senior tranches are usually
unfunded since the risk of loss is much lower.
• Unlike a cash CDO, investors in a senior tranche receive
periodic payments but do not place any capital in the
CDO when entering into the investment. Instead, the
investors retain continuing funding exposure and may
have to make a payment to the CDO in the event the
portfolio's losses reach the senior tranche.
• From an issuance perspective, synthetic CDOs take less
time to create. Cash assets do not have to be purchased
and managed, and the CDO's tranches can be precisely
structured.

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