CDS Deck - Credit Derivatives Stephen DeLetto November 3,...

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1 Credit Derivatives Stephen DeLetto November 3, 2010
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2 What is a Derivative? Derivatives are financial contracts, or financial instruments, whose values are derived from the value of some other (more fundamental) instrument known as the underlying Call option on IBM - IBM stock is the underlying An interest rate cap - LIBOR is the underlying A CDS on Verizon - Verizon bonds are the underlying
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3 What is a Credit Derivative? Credit derivatives is a collective term that includes credit default swaps (“CDS”) and other derivative contracts that incorporate an element of credit risk (i.e. credit is the underlying risk) Credit Linked notes (funded CDS) Synthetic indicies Options to enter into a CDS Synthetic CDOs
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4 Credit Derivative Products Credit Default Swaps (CDS) Basket CDS - Index Swaps Tranches / Synthetic CDOs Exotics/ Options Foundation
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5 Credit Default Swap - Basic Building Block Hedger Protection Buyer Risk Taker Protection Seller Fixed Fee Short the Credit Long the Credit Protection
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6 How do you trade CDS ? OTC Derivative contract between 2 parties Need to agree on the notional, reference entity, reference obligation, maturity, premium, credit events Credit events: Bankruptcy (e.g. Ch 11) Failure to pay (> $1m) Cash flows on trade if premium is 100 bps on $10MM notional: 1.0% * $10MM * (90/360) = $25,000 Standardized contracts result in deep liquidity and ease of execution
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7 CDS - Basic Contract Terms CDS trade under standardized derivative documents (ISDA) and credit lines/collateral agreements. Once in place trading requires 6 specific inputs: Notional Amount Risk exposure Reference Entity Credit Reference Obligation Establish seniority of credit risk Maturity Standard Mar, Jun, Sep, Dec or other Credit Events Bankruptcy, Failure to Pay Coupon Fixed rate premium to be Paid/Received
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8 Credit Default Swap - Trade Diagram Compare buying a floating rate bond: Verizon Bond Investor LIBOR + 70 bps Cash With selling protection and making a deposit: Investor Counterparty Bank Premium 70 bps Cash LIBOR Sale of protection on Verizon Credit Risk Credit Risk
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Pricing - Disaggregating Credit from Funding Default Swap Premium = Spread Over Funding +/- Adjustments Credit Spread (“S”) Premium (“P”) Funding (“L”) +100 bps +100 bps +Libor or UST Cash Perspective: Buy bond/Loan at the Asset Swap spread (L+ “S”), finance at Libor, and earn the net spread of “S”, or
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CDS Deck - Credit Derivatives Stephen DeLetto November 3,...

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