89_credit_derivatives - CREDIT DERIVATIVES Credit...

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CREDIT DERIVATIVES J. Wei, Department of Management, U of T 1 MGTD78 Credit derivatives defined Credit default swaps (CDS) Structure Details Credit indices CDS valuation Binary CDS Basket CDS CDS forwards and options Total return swaps, asset swaps CDS spread versus bond yield ABS, CDO, synthetic CDO 2007 financial crisis (cause and prevention)
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CREDIT DERIVATIVES J. Wei, Department of Management, U of T 2 MGTD78 Definition: derivatives whose payoff depends on the credit quality of a company or sovereign entity The market started to grow fast in the late 1990s Peak in 2007 (quiz) Established products (in order of importance) credit default swaps (CDS) collateralized debt obligations (CDO) total return swaps, asset swap CDS forward and options
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CREDIT DEFAULT SWAPS (CDS) J. Wei, Department of Management, U of T 3 MGTD78 The most popular credit derivatives Buyer acquires protection from the seller against default by a particular company or country (the reference entity) Example: Buyer pays a premium of 110 bps per year on $150 million of 10-year protection against company ABC Premium is known as the credit default spread or CDS spread. It is paid for life of contract or until default, whichever comes first When default occurs within the life of the contract, the buyer has the right to sell the bonds to the protection seller at the face value ($150 million in the above example) or simply cash settle
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CREDIT DEFAULT SWAPS (CDS) J. Wei, Department of Management, U of T 4 MGTD78 CDS Structure (similar to Figure 14.1) Default Protection Buyer, A Default Protection Seller, B 110 bps per year Payoff if there is a default by reference entity=150(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. For example, if market value is $60 million at default, then R = 60/150=0.4, and the payoff is 150(1 – 0.4) = $90 million.
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CREDIT DEFAULT SWAPS (CDS) J. Wei, Department of Management, U of T 5 MGTD78 Other details Payments are usually made quarterly or semiannually in arrears Due to arrears, a final accrual payment by the buyer is made in the event of default Illustration: suppose payments are semiannual in previous example. If there is a default after 2 years and 4 months and the recovery rate is 40%, then: the seller of the CDS will pay the buyer $150m × (1 – 0.4) = $90m the buyer will have already made 4 payments of $825,000 each [(0.011/2) × $150m = $825,000], and the last accrual payment is $825,000(4/6) = $550,000 Settlement can be specified as delivery of the bonds or in cash The face value of protection is called notional principal The occurrence of default is called the credit event (could be default or downgrade)
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CREDIT DEFAULT SWAPS (CDS) J. Wei, Department of Management, U of T 6 MGTD78 Attractions of CDS 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 Main users of CDS
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This note was uploaded on 05/10/2011 for the course MGT D78 taught by Professor Wei during the Spring '11 term at University of Toronto- Toronto.

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89_credit_derivatives - CREDIT DERIVATIVES Credit...

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