Structured Finance and the Financial Turmoil of 2007 2008

Some examples of this function will be shown in this

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the turmoil. Some examples of this function will be shown in this section, for both the single name and index CDS contracts. These various instruments will be discussed in respectively Section 4.1 (credit default swaps) and Section 4.2 (“synthetic” CDOs). Chart 7. CDS notional outstanding amounts 0 20 40 60 80 2H03 1H04 2H04 1H05 2H05 1H06 2H06 1H07 2H07 Credit Derivatives (ISDA) Credit Derivatives (BIS) Underlying debt Global Bank Assets 74 US Stock Mkt 22 US Bond Mkt 30 Trn USD SOURCE: ISDA and BIS. Chart 8. Buyers and sellers of credit derivatives Protection sellers (long credit risk) Protection buyers (short credit risk)
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BANCO DE ESPAÑA 32 DOCUMENTO OCASIONAL N.º 0808 4.1 Credit default swaps (CDS) Credit default swaps are the most important credit derivatives and consist of two main categories, i.e. single name contracts and index contracts. A single-name credit default swap is a bilateral, off-balance-sheet agreement between two counterparties in which one party, the protection seller or writer, offers the other party, the buyer, protection or insurance against credit risk on a specified amount of face value of bonds (the notional principal) against a credit event by a third party (reference entity, reference asset) for a specified period of time, in return for premium payments [Chacko et al. (2006)]. For example, a bank sells protection against the default of a bond (with a notional amount of say $1,000) issued by Ford Motor Company (i.e. the third party) to an investor who pays a premium or fee to the bank. Figure 7: Single name credit default swap Protection buyer Protection seller (or writer) Premium or fee (quarterly) Insurance payment, contingent on credit event affecting reference asset (of notional amount minus remaining market value of the reference asset) Reference asset (A specific bond or other debt instrument) Protection buyer (Holder of reference asset) Protection seller (or writer) Premium or fee (quarterly) Insurance payment, contingent on credit event and consisting of notional value of reference asset A. Single-name CDS cash settlement B. Single-name CDS physical settlement When credit event occurs: Physical transfer of reference asset. Reference asset (A specific bond or other debt instrument)
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BANCO DE ESPAÑA 33 DOCUMENTO OCASIONAL N.º 0808 A credit event is an event that affects materially the value of the reference asset and which triggers the termination of the CDS contract, as the insurance will have to be paid out. 4 In the absence of a credit event, the protection buyer will just pay the regular premium each quarter to the protection seller until the expiration of the CDS contract. If a credit event occurs, the buyer of protection pays the last quarterly premium in arrears to the seller. In a so-called “cash” settlement, the seller of protection makes the insurance payment to the protection buyer which consists of the notional amount of the bond (here $1,000) minus its remaining market value (see Figure 7A). In a so-called “physical” settlement, the protection
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