Talk:Credit default swap/Archive 1

Redundant Sentence
The third sentence of the second paragraph of the CDS definitions section reads: "This is because the expected value of protection payments is exactly equal and opposite to the expected value of the protection payments." This seems a bit redundant (and so accidentally meaningless), unless I'm missing something.

--Sangammon 12:45, 21 Jun 2005 (UTC)

CDS profiles are not like insurance
In the definition of credit default swap, there is a reference to the fact that the product has similar risk attributes to insurance. This is, in fact, misleading. By defintion, insurance-type protection covers actual losses incurred by the insurance purchaser. In other words, under an insurance contract, you need to have suffered an actual loss and be able to show the size / amount of the loss before you will be paid the insurance payout. You cannot insure against a potential loss that you would never suffer ( if the event you are insuring against occurs ). CDS ( or other standard credit derivatives ) however, have a pre-defined payoff structure that occurs when a particular event takes place ( ie the underlying credit defaults ), irrespective of whether or not the CDS protection buyer has suffer a loss or not. In the context of credit default risk, this key difference means that a CDS will allow you to 'short' credit ( ie sell credit risk you don't own ), while an insurance contract will not.


 * It was mentioned in the intro that CDS agreements enable debt holders to insure against credit events. How is this misleading?
 * Zain Ebrahim (talk) 10:42, 28 February 2008 (UTC)

Some questions on the example
The example is helpful but raises some questions...

1. If the Risky Corp bond pays a coupon, will the CDS cover any outstanding coupon payments in the event of a default? 1.b Why is the 50,000 payment quarterly? Why not semi-annual or something else?

2. In the event of default, does the pension fund recieve its refund immediately or does it have to wait until the maturity date of the underlying bond?

Thanks,

Rob

203.57.240.95 05:02, 8 May 2006 (UTC)

---Good question, this article doesn't have any mention of what happens on default event. Roughly, on default the buyer of protection delivers to the seller of protection an amount of bonds equal to the notional of the contract. The seller then pays him par for those bonds. If the bond was trading at a discount then the buyer is compensated if at a premium then no. ---This corresponds to the contract roll date. Though for some contracts it's semi-annual and monthly rolls. ---30 business days after default the pension fund (buyer of protection) delivers any underlying bonds to the seller of protection. That's when he gets his "refund". John.gmail 14:50, 5 September 2006 (UTC)

Comments on "Criticism to Credit Derivatives"
First Point (notional of outstanding CDSs is higher than that of the outstanding underlying bonds): correct, and could indeed generate a problem in the event of default. But this point ignores the fact that CDSs are over-the-counter instruments and, unlike in the case of assets traded on exchanges, the total outstanding volume doesn't necessarily equal the total outstanding exposure (exposure is actually much lower). For example, one counterparty that sells $10M protection on a name to counterparty A may buy the same $10M protection later from counterparty B to offset the first trade. This appears as $20M of outstanding volume but doesn't mean $20M of total added market exposure. Granted there is no way to know what the exact numbers are so there is some risk there, just not nearly as much as a superficial analysis would suggest. Enron, WorldCom and Delphi happened (Delphi had multiples of CDSs outstanding over their bonds) and the market held up very well.

The second criticism is in my view even more problematic. It is true that there is a Basis (CDS Spread - Spread on Underlying Asset) in the credit default swap market, but the comparison to the history of the perpetual FRN notes is bogus because an explanation was already found. If you have AAA credits that fund themselves below Libor, and then you have a CDS paying a positive spread, then you can have arbitrage right? Wrong, since to do that you need to short the bond, which is sometimes not possible and usually expensive. The alternative is to set up a note, but then you need to have a vehicle to set up the note and this involves costs. If the basis is the other way around (which is usually the case for AA to BBB credits) then you have to fund yourself to explore the difference and that usually implies AA ratings max (Libor minimum cost). If you go below investment grade (BB+ and down) the basis usually becomes positive again, but now because you have the "cheapest to deliver option" in the CDS that is not present in the bond (which becomes more valuable since the credit is nearer default), plus the fact that the CDS market is more liquid and usually reacts faster than the bond market to changes in the credit quality of the underlying. There are other factors such as leverage and bonds trading at a premium or discount (CDSs always protect par), and the list goes on. The fact is that there are plenty of explanations. And besides, the difference in price is small, like a couple basis points, which is far from the difference between the present value of principal in a perpetual and in a 5 year FRN... not likely at all to bring "devastating" consequences to the market should everyone be wrong.

Very good points. However it does seem odd that the Duffie model assumes away the cost of unwinding the asset swap. With US rates having fallen some 70 basis points in just a few months, the cost of unwinding this swap (in the event of default) would appear to be non-neglible compared to the basis. Can an investor hedge this contingent risk? I guess it is possible but wouldnt it be very expensive? Andyseaman 21:48, 1 November 2006 (UTC)

I take your point (without entering into the Duffie Model if I may). Interest rate risk can be hedged away when you buy a bond by either selling Treasuries against it (common practice in the credit market, even though I mention above sometimes it's hard to short a bond you can do that with Treasuries relatively easy) or entering into an interest rate swap as a fixed rate payer. If the bond holds for your investment horizon you're fine regardless of the level of the rates, but if it defaults then you arguably lose one side of the structure (the defaulted bond starts trading on an expected recovery basis and interest rates stop playing a noticeable role in its pricing) and become exposed again to interest rates when you unwind the hedge. You still have Floating Rate Notes that wouldn't have this risk. Beyond that you need some contingent structure that pays the inverse of the short Treasury upon default of the referenced Bond and that may get a little more expensive (but shouldn't be much since you're talking CDS Spread scaled down since loss given default would equal the expected MTM on the Treasury Position which should be much smaller than the expected loss given default on any entity). Also, a lot of players see this from a portfolio management perspective, and this dimishes the problem if you're diversified. Finally, you're talking about a jump to default situation. In practice what you have is a spread over treasuries that varies, and a distressed bond would be trading below par, so in the practical case that you are exposed to this interest rate risk (bought CDS protection and bought the bond) you'll be made whole at par through the CDS and will likely make money regardless of interest rate changes (it is possible to do this with premium bonds but then no one ignores this risk or pretends it doesn't exist). The other side of this trade is usually a dealer (a bank) which hedges both things separately (the "portfolio" effect I mentioned before) - also banks usually sell the bond from inventory, the investor to put up the opposite trade would have to sell the bond short and we go back to the difficult / impossible scenario so it's not a real problem. In any case, from whatever perspective you look, if you keep the practicalities in mind (again the "everything is explained" point I made above) I don't think all this could get close to exposing the market to huge systemic risks or any looming drastic change in CDS / structured credit pricing... we had some tests already, and probably will have more in the coming years, so we'll see. If I'm still around and this piece is still around when anything drastic happens I promise to be the first one back here, probably posting my resume from home... until then, back to work!

As a follow to the First Point above in this section of comments: wouldn't the ultimate loss realized by the collective CDS sellers in the example given be $600MM ($1Bn - $400MM recovery), and not a multiplying affect? I say this because at the beginning of the article it states "Most CDS contracts are physically settled, whereupon a 'triggering event' forces the protection seller to pay the face value of the 'reference obligation' against the protection buyer's obligation to deliver the protected debt." It would seem to me that only $1Bn of notional securities could be delivered, therefore aggregate sellers of protection would only need to pay against those claims (in other words, the CDS sellers are stepping into the shoes of the bond holders, therefore they only take a loss of $600MM). Probably would be settled through a series of redundant transactions as mentioned in the First Point. This is merely a question, as I am no expert in the area. Thanks, Scott.

Protection sellers must pay the total outstanding notional of protection they sold, minus recovery. Upon default, dealers have an auction where a price for the defaulted bonds is determined (the "recovery value"), and from there contracts are settled either by physical delivery or cash. This was developed precisely to circumvent the problem of more protection being written on an issuer than the total of outstanding bonds they have. In the absence of this auction, protection buyers who didn't have bonds would need to go to the market and buy bonds. Since demand would outsize supply, you would have the same effect of a big "short squeeze" with bond prices shooting up. In this case, the CDS would pay out a value that would most likely not represent the recovery value that will ultimately be realized given the high price paid on the deliverable bond (due to purely technical factors). In the absence of the auction the market would also be more susceptible to manipulation. Hope this helps. —Preceding unsigned comment added by 167.203.158.140 (talk) 12:54, 28 December 2007 (UTC)

Modified and Modified Modified
I think this article should have a section on Modified and Modified Modified, perhaps as a subsection within the terms, since these are possibly the most significant variations on the standard CDS.CreditQuant 13:43, 27 February 2007 (UTC)

I agree. It should mention the difference between R, mod-r, & mod-mod R. A good reference is ISBN:978-1904339120 Brianegge (talk) 12:08, 29 November 2007 (UTC)

Assessment comment
Substituted at 14:35, 1 May 2016 (UTC)