Credit Derivatives

Chapter 23

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Credit Derivatives

Derivatives where the payoff depends on the credit quality of a company or sovereign entity The market started to grow fast in the late 1990s

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Credit Default Swaps (page 501)

Buyer of the instrument acquires protection from the seller against a default by a particular company or country (the reference entity) Example: Buyer pays a premium of 90 bps per year for $100 million of 5-year protection against company X Premium is known as the credit default spread. It is paid for life of contract or until default If there is a default, the buyer has the right to sell bonds with a face value of $100 million issued by company X for $100 million (Several bonds may be deliverable)
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

CDS Structure
90 bps per year Default Protection Buyer, A Default Protection Seller, B

Payoff if there is a default by reference entity=100(1-R)

Recovery rate, R, is the ratio of the value of the bond issued by reference entity immediately after default to the face value of the bond
Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Other Details

Payments are usually made quarterly or semiannually in arrears In the event of default there is a final accrual payment by the buyer Settlement can be specified as delivery of the bonds or a cash equivalent amount Suppose payments are made quarterly in the example just considered. What are the cash flows if there is a default after 3 years and 1 month and recovery rate is 40%?
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Moodys Statistics on Recovery Rates (1982-2007) Table 23.1 page 504

Class Senior secured Senior unsecured Senior subordinated Subordinated Junior subordinated Average recovery rate (%) 51.9 36.7 32.4 31.2 23.9

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Cheapest-to-deliver bond

Usually there are a number of bonds that can be delivered in the event of a default The protection buyer can choose to deliver the bond with the lowest price In the case of cash settlement the calculation agent will base the calculation of the payoff on the cheapest-to-deliver bond
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Attractions of the CDS Market

Allows credit risks to be traded in the same way as market risks Can be used to transfer credit risks to a third party Can be used to diversify credit risks

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Credit Indices

CDX NA IG tracks the average CDS spread for a portfolio of 125 investment grade (rated BBB or above) North American companies iTraxx Europe tracks the average CDS spread for a portfolio of 125 investment grade European companies

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

CDS Spreads and Bond Yields

505)

(See page

Portfolio consisting of a 5-year par yield corporate bond that provides a yield of 6% and a long position in a 5-year CDS costing 100 basis points per year is (approximately) a long position in a riskless instrument paying 5% per year This shows that CDS spreads should be approximately the same as bond yield spreads

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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Valuation

Suppose that conditional on no earlier default a reference entity has a (risk-neutral) probability of default of 2% in each of the next 5 years Assume payments are made annually in arrears, that defaults always happen half way through a year, and that the expected recovery rate is 40% Suppose that the breakeven CDS rate is s per dollar of notional principal

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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Unconditional Default and Survival Probabilities (Table 23.2)

Time (years) 1 2 Default Probability 0.0200 0.0196 Survival Probability 0.9800 0.9604

3
4 5

0.0192
0.0188 0.0184

0.9412
0.9224 0.9039
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Calculation of PV of Payments
Table 23.3 (Principal=$1) Time (yrs) 1 2 3 Survival Prob 0.9800 0.9604 0.9412 Expected Paymt 0.9800s 0.9604s 0.9412s Discount Factor 0.9512 0.9048 0.8607 PV of Exp Pmt 0.9322s 0.8690s 0.8101s

4
5 Total

0.9224
0.9039

0.9224s
0.9039s

0.8187
0.7788

0.7552s
0.7040s 4.0704s
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Present Value of Expected Payoff

Table 23.4 (Principal = $1) Time (yrs) 0.5 Default Rec. Expected Discount PV of Exp. Probab. Rate Payoff Factor Payoff 0.0200 0.4 0.0120 0.9753 0.0117

1.5
2.5 3.5 4.5 Total

0.0196
0.0192 0.0188 0.0184

0.4
0.4 0.4 0.4

0.0118
0.0115 0.0113 0.0111

0.9277
0.8825 0.8395 0.7985

0.0109
0.0102 0.0095 0.0088 0.0511
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

PV of Accrual Payment made in event of a Default. Table 23.5 (Principal=$1)

Time 0.5 1.5 2.5 Default Prob 0.0200 0.0196 0.0192 Expected Accr Pmt 0.0100s 0.0098s 0.0096s Disc Factor 0.9753 0.9277 0.8825 PV of Pmt 0.0097s 0.0091s 0.0085s

3.5
4.5 Total

0.0188
0.0184

0.0094s
0.0092s

0.8395
0.7985

0.0079s
0.0074s 0.0426s
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Putting it all together

PV of expected payments is 4.0704s+0.0426s=4.1130s The breakeven CDS spread is given by 4.1130s = 0.0511 or s = 0.0124 (124 bps) The value of a swap with a CDS spread of 150bps would be 4.11300.0150-0.0511 or 0.0106 times the principal.
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Implying Default Probabilities from CDS Spreads

Suppose that the mid market spread for a 5 year newly issued CDS is 100bps per year We can reverse engineer our calculations to conclude that the default probability is 1.61% per year. If probabilities are implied from CDS spreads and then used to value another CDS the result is not sensitive to the recovery rate providing the same recovery rate is used throughout
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Other Credit Derivatives

Binary CDS First-to-default Basket CDS Total return swap Credit default option Collateralized debt obligation

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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Binary CDS (page 510)

The payoff in the event of default is a fixed cash amount In our example the PV of the expected payoff for a binary swap is 0.0852 and the breakeven binary CDS spread is 207 bps

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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First to Default Basket CDS

(page 510)

Similar to a regular CDS except that several reference entities are specified and there is a payoff when the first one defaults Could also be structured as second, third, or nth to default Valuation is more difficult because of default correlation between the reference entities

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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Total Return Swap (pages 511-513)

Agreement to exchange total return on a corporate bond for LIBOR plus a spread At the end there is a payment reflecting the change in value of the bond Usually used as financing tools by companies that want an investment in the corporate bond
Total Return on Bond

Total Return Payer

LIBOR plus 25bps

Total Return Receiver

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

CDS Options (page 513)

Example: European option to buy 5 year protection on Ford for 280 bps starting in one year. If Ford defaults during the one-year life of the option, the option is knocked out Depends on the volatility of CDS spreads

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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Collateralized Debt Obligation

(page 513)

A pool of debt issues are put into a special purpose trust Trust issues claims against the debt in a number of tranches

First tranche covers x% of notional and absorbs first x% of default losses Second tranche covers y% of notional and absorbs next y% of default losses etc

A tranche earns a promised yield on remaining principal in the tranche

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Cash CDO Structure (Figure 23.3)

Bond 1 Bond 2 Bond 3 Tranche 4 Loss >25% Yield = 6% Tranche 3 Losses: 15-25% Yield = 7.5%

Bond n

Trust

Tranche 2 Losses: 5-15% Yield = 15% Tranche 1 Losses: 0-5% Yield = 35%
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Average Yield 8.5%

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Synthetic CDO

When an ABS is created from bonds it is called a cash CDO A long position in a corporate bond has the same credit risk as the seller of a credit default swap Instead of buying the bonds the arranger of the CDO sells credit default swaps (Called a synthetic CDO)
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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Single Tranche Trading

Where one tranche is traded without the other tranches being created The synthetic CDO structure is used as a reference for defining the cash flows (but it is never actually created)

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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Indices

CDX NA IG: portfolio of 125 North American investment grade companies

Tranches: 0-3%, 3-7%, 7-10%, 10-15%, 1530%, 30-100%

iTraxx Europe: portfolio of 125 European investment grade companies

Tranches: 0-3%, 3-6%, 6-9%, 9-12%, 12-22%, 22-100%

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Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

Mid-Market Quotes for iTraxx Europe (Table 23.7, page 516)

Tranche 0-3%
Jan 31, 2007 Jan 31, 2008 Jan 31, 2009 10.34% 30.98% 64.28%

3-6%
41.59 316.90 1185.63

6-9%
11.95 212.40 606.69

9-12%
5.60 140.00 315.63

12-22%
2.00 73.60 97.13

Index
23 77 165

Fundamentals of Futures and Options Markets, 7th Ed, Ch 23, Copyright John C. Hull 2010

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