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Level 59

Using Credit Derivatives

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Credit Defaut Swap
CDS is an insurance contract. Reference obligation is the fixed income security on which swap is written
what position does a CDS create in the reference obligation?
how does the value of CDS change as credit quality and market price of reference declines?
what risk does it protect from?
only credit risk, not interest rate risk
how does it settle?
cash or physical delivery (latter = usual case)
physical settlement
buyer gives the reference obligation, receives par value
cash settlement
buyer receives par value - market value
how are CDS and corporate bonds similar?
when credit risk increases, both CDS premiums and bond yields increase
advantages of using CDS
risk management: separate credit risk and interest rate risk
major users of CDS
commercial banks: largest participant, hedge exposure, satisfy regulators and buy protection
synthetic CDO
exposure to a basket of CDSs is sold
trading strategies
basis trade
basis trade
CDS premium compared to the asset swap spread of underlying bond. If spread higher than CDS - basis negative, investor should buy the bond and buy CDS
curve trade
short term vs. long term prospects
index trade
use CDS to exploit perceived mispricing
options trade
receiver option: right to sell CDS
capital structure trade
<> views on various securities
correlation trade
first to default swap, typically 5 CDS, provide protection for the first default. Higher number of CDS, higher premium, higher default correlation, lower premium
Corp Bond: Credit Risk, Funding risk, RF rate
what are the risk factors in each kind of CDS corp bond, asset swap, VW cds
synthetic CDO market
Says that you can select a number of companies and put under your CDO watch.
Basis trades
you buy CDS against a bond paying a higher rate and make the spread
capital structure trades
making a call between capital sructure of home company and subsidiary which ever you feel will be in better shap
whats a first to default basket.
you have a basket of companies and if one defaults you collect notional on all companies in the basket.
CDO structure strategy
trading different parts of the capital structure based on how you feel default possibility will change over the coming time frame