Hull Chapter 24 - Credit Derivatives Flashcards

1
Q

Credit Default Swap

A

A credit default swap represents insurance against a default by a particular company on a particular issuance of debt.

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2
Q

CDS - credit event

A

This is the technical definition of what constitutes a “default”, such as the failure to make a payment when it is due, a restructuring of debt or bankruptcy.

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3
Q

CDS Spread

A

The CDS spread is defined as the payment rate such that the present values of the buyer and seller payments are equal. In other words, it is the payment rate such that the value of the
swap is zero at inception.

As a result, the CDS spread should be approximately equal to the differences in the par yields for the corporate bond and the risk free bond. If the risk free rate is the LIBOR/swap rate, then
this difference will equal the asset swap rate

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4
Q

Marking to Market

A

At any future date, use the known CDS spread to mark an existing CDS to market.

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5
Q

Default Probabilities used to determine CDS spread - risk neutral or real world?

A

risk-neutral default probabilities

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6
Q

CDS contracts played a fairlycritical role in fueling the credit and securitization bubble that burst so badly in 2007-2009.

A

Since the universe of corporate bonds and even securitized tranches is relatively small, it was quite common for CDS contracts to be used in place of actual bonds in CDO structures.

The ability to create hundreds or thousands of CDOs from the
same underlying risk using CDS instead of the actual bonds partly contributed to the magnitude of the crisis. When a single corporate or structured bond defaulted, it tended to effect numerous (synthetic) CDO structures that didn’t contain the actual bond but contained instead the CDS on that bond.

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7
Q

Total Return Swaps

A

agreements to exchange the total return on a bond, including coupons, interest and capital gains/losses for LIBOR plus a spread.

One party, the swap receiver, pays LIBOR plus a spread every six months and receives the coupons from the reference bond every six months.

On the final swap date, the capital gain/loss on the bond is paid from the payer to the receiver. If there is a loss, the payment is made from the receiver to the payer.

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8
Q

Why do people buy total return swaps?

A

one party can “invest” in a risky bond without having to actually pay for it up front. Instead, they have another party, the swap payer, buy the bond and the swap receiver agrees to make LIBOR plus a spread payments to the payer much as they would do if they had borrowed the money from the payer in the first place to buy the bond on their own. The payer’s swap payments then pass along the economic interest in the bond to the receiver, so that if the bond suffers a default or other loss in value, the receiver suffers.

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9
Q

Spread for total return swaps

A

Because this is much like an exchange of a LIBOR bond for the reference bond, we might expect the spreads to be set to equate the values of these two bonds.

However, in the event of the default of the receiver, the payer will lose money if the reference bond had declined in value and therefore the payer will demand a spread to LIBOR based on the receiver’s credit quality and the correlation of default between the receiver and the reference bond.

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10
Q

Synthetic CDOs

A

A pool consist solely of credit default swaps.

To construct this, special purpose vehicle sells credit protection to buys via short positions in CDS contracts. The CDS spreads paid are passed through, in some fashion in accordance to the relative risk they assumed, to the investors in the various CDO tranches. The proceeds from the CDO investors (the ultimate credit risk takers) serve as collateral for the CDS contracts and if a default occurs, payments are made out of these funds.

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11
Q

Hull notes that a critical input to the determination of the expected cash flows in a CDS is the recovery rate estimate that we cannot observe. However, for plain vanilla credit default swaps the CDS spread is generally insensitive to different assumptions about the recovery rate. Why is this the case?

A

Because the recovery rate assumption enters into the pricing of the CDS in two largely offsetting ways. It affects the risk neutral default probabilities and it affects the payoffs in the event of default. Larger recovery rates imply larger default probabilities and smaller CDS payoffs and so these effects are offsetting.

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12
Q

What is a first-to-default credit default swap?

A

In a first-to-default basket CDS there are a number of reference entities. When the first one defaults there is a payoff (calculated in the usual way for a CDS) and basket CDS terminates.

The value of a first-to-default basket CDS decreases as the correlation between the reference entities in the basket increases. This is because the probability of a default is high when the correlation is zero and decreases as the correlation increases.

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