My works largely centers around credit and derivatives. The basic element is the credit default swap. Here is a brief overview.
Definition:
In a credit default swap (CDS), the buyer makes a periodic or an upfront payment to the seller of the default swap. The default swap seller promises to make a payment in the event of default of a reference obligation, which is usually a bond or a loan.
• Simplified example.
Bank A buys £10 mm of protection for 5 years on General Motors (GMAC) at 100 basis points per year from Hedge fund B. GMAC defaults after 1 year. The Bank delivers a bond (cheapest to deliver) to the Hedge fund. The hedge fund pays £10mm to the bank.
There are 5 seniorities/tiers
SNRFOR- Senior Unsecured Debt (Corporate/Financial), Foreign Currency Sovereign Debt (Gvt)
SUBLT2- Subordinated or Lower Tier2 Debt (Banks)
JRSUBUT2- Junior Subordinated, or Upper Tier 2 Debt (Banks)
PREFT1- Preference Shares, or Tier 1 Capital (Banks)
SECDOM- Secured Debt (Corporate/Financial) or Domestic Currency Sovereign Debt (Gvt)
The first 2 (Senior and Subordinated) are the most actively traded. A subordinated CDS will trade on a higher spread as the recovery rate is lower.
Default
ISDA specifies six possible events
1. Bankruptcy
2. Failure to pay
3. Obligation acceleration
4. Obligation default
5. Repudiation
6. Restructuring
A CDS can have four different types of restructuring
1. No restructuring (XR) Unusual
2. Original restructuring (CR) US until 2001, EU until 2003/2004)
3. Modified Restructuring (MR) US 2001-2004. Modified Modified restructuring (MM) EU and US 2004-
The credit spreads should satisfy the relationship CR>MM>MR>XR
4. Recovery rate
Typically, a CDS desk assumes a recovery rate of 40%. However, recovery rate depends on a number of factors.
(Sector: In 2003 the average recovery rate for the Utility Gas sector was 48%, whereas for Technology it was 9.4%• Economic cycle: Recovery rates fall during recession• Seniority: In 2003 Senior bonds had an average recovery rate of 44.4% whereas subordinated bonds had 29.2 (value weighted)
Reference entity
Markit identify around 2400 reference entities, with Markit RED covering around 1800 of these.
Indices
The Dow Jones CDX and ITraxx indices are the de facto benchmark for credit investors. These are examples of Collateralized Debt Obligations (CDO’s). There are several indexes within each e.g DJ North America High Yield Index and ITraxx Europe. Each index consists of a basket of reference entities e.g. ITraxx Europe consists of 125 European entities. A new series of indices is issued every 6 months (March and September) and the underlying reference entities are reconstituted. Investing in indices is slightly different to a single name CDS investment in as trading is executed at a fixed rate (e.g ITraxx Europe main is 35 b.p.s. If the fair market value differs from this as time progresses, and upfront premium is incurred.Markit publishes red codes for indices.The DJ ITraxx and CDX are also actively traded in tranching structure. In the case of ITraxx Europe, the most exposed tranche (equity) is liable for the first 0-3% of losses. The most senior tranche is liable for losses from 12-22%. Tranches in between are known as mezzanine tranches. The equity tranche is usually quoted with an upfront spread, and all tranches are quoted with a correlation. Low correlation is bad for the equity tranche and good for the senior tranche. The opposite is true for high correlation.
Upfront
The majority of CDS trade with a premium of <500 with the 1 year spread being less than the 5 year. However, for distressed companies, the opposite happens, with 1 year premium reaching as high as 4000 bps – the curve becomes inverted. When this happens, the spread is sometimes quoted as a percentage + 500 bps running, when the protection buyer pays a percentage of the notional upfront followed by the usual running spread.
