Describe what credit derivatives look like and how they are employed, and discuss the risks that might stem from them.
The idea
A credit derivative transfers credit risk from a protection buyer to a protection seller. In a credit default swap the buyer pays a periodic spread, and R denotes the recovery rate on the reference entity's debt. If the reference entity has a credit event, the seller makes a contingent payment to the buyer, which is: Payout = Notional × (1 − R). Other forms include total return swaps, credit-linked notes and tranches of collateralised debt obligations. Banks use them to hedge loans without selling them, investors to take credit exposure without funding, and traders to express relative value views. The risks are counterparty risk on the seller and wrong-way risk when seller and reference entity are highly correlated. Basis and documentation risk also matter, since a restructuring may not count as a credit event. Jump-to-default and liquidity risk arise as well. A hedge replaces the reference entity risk with seller risk. Exam point: protection is only as strong as the seller, especially when both fail together.
Formulas
CDS protection payment on a credit event
Protection payment = N × (1 − R)
- N
- the notional of protection bought
- R
- the recovery rate on the reference obligation
Paid by the seller only after a credit event as the contract defines it. The periodic spread is a separate cost to the buyer and is not netted from the payment.
A practice question
Which description of a single-name credit default swap is correct?
- The protection seller pays a periodic premium, and the buyer pays the loss on the reference entity if a credit event occursWhy not: Reverses the roles of buyer and seller.
- The protection buyer pays a periodic premium, and the seller pays the loss on the reference entity if a credit event occurs - correct
- The buyer pays the premium and the seller pays the notional at maturity whether or not a credit event has occurredWhy not: Removes the contingency; the seller pays only on a credit event.
- The seller delivers the reference entity's bonds at maturity in return for the buyer's premium paymentsWhy not: Invents a delivery of bonds by the seller; physical settlement involves the buyer delivering defaulted bonds.
A CDS is a contingent protection payment in exchange for a premium. The buyer pays the spread; the seller pays notional x (1 - recovery) on a credit event.
A harder one
A bank buys CDS protection on a sovereign from a domestic bank whose solvency depends heavily on the sovereign. Which risk is most significant?
- Wrong-way risk, since the seller and the sovereign are likely to fail together - correct
- Prepayment risk, because the sovereign may redeem its bonds early and shorten the hedgeWhy not: Prepayment risk concerns mortgage-type assets, not the dependence between seller and reference entity.
- The seller's default matters only if the sovereign does not default, since that is when the hedge is unusedWhy not: Backwards: the hedge matters when the sovereign defaults, and the seller's failure then removes the payment.
- Currency risk on the premium payments, which is the only material risk in a bought CDSWhy not: Premium currency is minor compared with the loss of protection when seller and reference entity fail together.
Wrong-way risk arises when the counterparty's credit quality deteriorates as the exposure rises. A bought CDS on a sovereign from a sovereign-dependent bank is a clear example.
The hardest tier
A bank hedges a loan with a CDS whose credit events do not include restructuring. The borrower restructures the loan by extending its maturity and cutting the coupon, and the CDS does not pay. This outcome is best described as:
- Counterparty risk, because the protection seller defaulted on its obligationWhy not: The seller did not default; the contract simply did not pay because the event was not covered.
- Documentation or credit event definition risk, which leaves the bank partly unhedged - correct
- Wrong-way risk, because the seller and borrower defaulted togetherWhy not: No default occurred at the seller; the problem is the scope of the credit event definition.
- Liquidity risk, because the bank could not unwind the CDS in a market with few dealersWhy not: Nothing here involves unwinding; the issue is that the contract does not respond to the event.
Hedge effectiveness depends on credit event definitions. A loan can lose value through restructuring while a no-restructuring CDS does not pay, leaving the bank unhedged.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Derivatives
- Say what a derivative is and show how trading derivatives exposes a party to counterparty credit risk.
- Contrast the exchange-traded and over-the-counter (OTC) segments of the derivatives world, including how each market is structured.
- Outline how a derivative transaction is cleared.
- Name who takes part in derivatives collateralization and outline how collateral is used.
- Define the ISDA (International Swaps and Derivatives Association) Master Agreement, together with the protections it gives against risk and the events of default it covers.
- Describe how OTC derivatives are centrally cleared, and discuss the CCP (central counterparty) in terms of its roles, mandate, benefits and drawbacks.
- Account for the margin rules that apply to centrally-cleared derivatives and to those not centrally cleared.
- Say what SPVs, DPCs (derivatives product companies), monolines and CDPCs (credit derivatives product companies) are, and set out why they are limited as means of mitigating risk.
- Outline the methods for modelling derivatives risk and the difficulties met in doing so.