SETTLEMENT OF CREDIT DEFAULT SWAP (CDS)

 Settlement of CDS

Broadly, following are main ways of settlement of CDS.

(i) Physical Settlement – This is the traditional method of settlement. It involves the delivery of Bonds or debts of the reference entity by the buyer to the seller and seller pays the buyer the par value.

For example, as mentioned above suppose Danger Corp. defaults then SS Bank will pay
$ 10 Million to BB Corp. and BB Corp will deliver $10 Million face value of Bonds to SS Bank.

(ii) Cash Settlement- Under this arrangement seller pays the buyer the difference between par value and the market price of a debt (whatever may be the market value) of the reference entity. Continuing the above example suppose, the market value of Bonds is 30%, as market is of belief that bond holder will receive 30% of the money owed in case company goes into liquidation. Thus, the SS Bank shall pay BB Corp. $ 10 Million - $3 million (100% - 30%) = $ 7 Million.

To make Cash settlement even more transparent, the credit event auction was developed. Credit event auction set a price for all market participants that choose to cash settlement.

 http://www.comgurukul.com/educational-books/gst-book/

PARTIES TO CREDIT DEFAULT SWAP (CDS)

 Parties to CDS

In a CDS at least three parties are involved which are as follows:

i. The initial borrowers- It is also called a ‘reference entity’, which are owing a loan or bond obligation.

ii. Buyer- It is also called ‘investor’ is the buyer of protection. The buyer will make regular payment to the seller for the protection from default or credit event of reference entity.

iii. Seller- It is also called ‘writer’ of the CDS and makes payment to buyer in the event of credit event of reference entity. It receives a regular pay off from the buyer of CDS.

Example-
Suppose BB Corp. buys CDS from SS Bank for the Bonds amounting $ 10 million of Danger Corp. In such case, the BB Corp. will become the buyer, SS Bank becomes seller and Danger Corp. becomes the reference entity. BB Corp. will make regular payment to SS Bank of the premium and if Danger Corp. defaults on its debts, the BB Corp. will receive one time payment and CDS contract is terminated.

 http://www.comgurukul.com/educational-books/gst-book/

USES OF CREDIT DEFAULT SWAP

 Uses of Credit Default Swap
Following are the main purposes for which CDS can be used.

(a) Hedging- Main purpose of using CDS is to neutralize or reduce a risk to which CDS is exposed to. Thus, by buying CDS, risk can be passed on to CDS seller or writer.

(b) Arbitrage- It involves buying a CDS and entering into an asset swap. For example, a fixed coupon payment of a bond is swapped against a floating interest stream.

(c) Speculation- CDS can also be used to make profit by exploiting price changes. For example, a CDS writer assumed risk of default, will gain from contract if credit risk does not materialize during the tenure of contract or if compensation received exceeds potential payout.

 http://www.comgurukul.com/educational-books/gst-book/

MAIN FEATURES OF CREDIT DEFAULT SWAP (CDS)

 Main Features of CDS
The main features of CDS are as follows:

1. CDS is a non-standardized private contract between the buyer and seller. Therefore, it is covered in the category of Forward Contracts.

2. They are normally not traded on any exchange and hence remains free from the regulations of Governing Body.

3. The International Swap and Derivative Association (ISAD) publishes the guidelines and general rules used normally to carry out CDS contracts.

4. CDS can be purchased from third party to protect itself from default of borrowers.

5. Similarly, an individual investor who is buying bonds from a company can purchase CDS to protect his investment from insolvency of that company. Thus, this increases the level of confidence of investor in Bonds purchased.

6. The cost or premium of CDS has a positive relationship with risk attached with loans. Therefore, higher the risk attached to Bonds or loans, higher will be premium or cost of CDS.

7. If an investor buys a CDS without being exposed to credit risk of the underlying bond issuer, it is called “naked CDS”.

 http://www.comgurukul.com/educational-books/gst-book/

CREDIT DEFAULT SWAP(CDS)

CREDIT DEFAULT SWAP (CDS)
It is a combination of following 3 words:

Credit : Loan given Default : Non payment

Swap : Exchange of Liability or Risk

Accordingly, CDS can be defined as an insurance (not in stricter sense) against the risk of default on a debt which may be debentures, bonds etc.

Under this arrangement, one party (called buyer) needing protection against the default pays a periodic premium to another party (called seller), who in turn assumes the default risk. Hence, in case default takes place then there will be settlement and in case no default takes place no cash flow will accrue to the buyer alike option contract and agreement is terminated. Although it resembles the options but since element of choice is not there it more resembles the swap arrangements.

Amount of premium mainly depends on the price of underlying and especially when the credit risk is more.

 http://www.comgurukul.com/educational-books/gst-book/

RISK INVOLVED IN CDOs

 Risk involved in CDOs

CDOs are structured products and just like other financial products hence are also subject to various types of Risk.

The main types of risk associated with investment in CDOs are as follows:
(1) Default Risk: - Also called ‘credit risk’, it emanates from the default of underlying party to the instruments. The prime sufferers of these types of risks are equity or junior tranche in the waterfall.

(2) Interest Rate Risk: - Also called Basis risk and mainly arises due to different basis of interest rates. For example, asset may be based on floating interest rate but the liability may be based on fixed interest rates. Though this type of risk is quite difficult to manage fully but commonly used techniques such as swaps, caps, floors, collars etc. can be used to mitigate the interest rate risk.

(3) Liquidity Risk: - Another major type of risk by which CDOs are affected is liquidity risks as there may be mismatch in coupon receipts and payments.

(4) Prepayment Risk: - This risk results from unscheduled or unexpected repayment of principal amount underlying the security. Generally, this risk arises in case assets are subject to fixed rate of interest and the debtors have a call option. Since, in case of falling interest rates they may pay back the money.

(5) Reinvestment Risk: - This risk is generic in nature as the CDO manager may not find adequate opportunity to reinvest the proceeds when allowed for substitutions.

(6) Foreign Exchange Risk: - Sometimes CDOs are comprised of debts and loans from countries other than the country of issue. In such a case, in addition to above mentioned risks, CDOs are also subject to the foreign exchange rate risk as discussed in the paper Strategic Financial Management.

 http://www.comgurukul.com/educational-books/gst-book/

TYPES OF CDOs

 Types of CDOs
The various types of CDOs are as follows: 

(a) Cash Flow Collateralized Debt Obligations (Cash CDOs)
Cash CDO is CDO which is backed by cash market debt or securities which normally have low risk weight. This structure mainly relies on the collateral’s risk weight and collateral’s ability to generate sufficient cash to pay off the securities issued by SPV. 

(b) Synthetic Collateralized Debt Obligations

It is similar to Cash Flow CDOs but with the difference that instead of transferring of ownerships of collateral to SPV (a separate legal entity), synthetic CDOs are structured in such a manner that credit risk of transferred by the originator without actual transfer of assets.

Normally the structure resembles the hedge funds where in the value of portfolio of CDO is dependent upon the value of collateralized instruments and market value of CDOs depends on the portfolio manager’s ability to generate adequate cash and meeting the cash flow obligations (principal and interest) in timely manner.

While in cash CDO the collateral assets are moved away from Balance Sheet, in synthetic CDO there is no actual transfer of assets instead economic effect is transferred.

This effect of transfer economic risk is achieved by creating provision for Credit Default Swap (CDS) or by issue of Credit Linked Notes (CLN), a form of liability.

Accordingly, this structure is mainly used to hedge the risk rather than balance sheet funding. Further, for banks, this structure also allows the customer’s relations to be unaffected. This was started mainly by banks who want to hedge the credit risk but not interested in taking administrative burden of sale of assets through securitization.

Technically, speaking synthetic CDO obtain regulatory capital relief benefits vis-à-vis cash CDOs. Further, they are more popular in European market due to the reason of less legal documentation requirements. Synthetic CDOs can also be categorized as follows:

(a) Unfunded: - It will be comprised only CDs.

(b) Fully Funded: - It will be through issue of Credit Linked Notes (CLN).

(c) Partially Funded: - It will be partially through issue of CLN and partially through CDs. 

(c) Arbitrage CDOs
Basically, in Arbitrage CDOs, the issuer captures the spread between the return realized collateral underlying the CDO and cost of borrowing to purchase these collaterals. In addition to this issuer also collects the fee for the management of CDOs. This arbitrage arises due to acquisition of relatively high yielding securities with large spread from open market.

 http://www.comgurukul.com/educational-books/gst-book/