2:02

This credit event has happened somewhere in between two coupon payments.

Â There should have been a coupon payment there.

Â There should have been a coupon payment there.

Â So, the credit event happened right in between these two coupon payments.

Â So, at the next coupon payment date, the buyer has to pay the accrued interest

Â over this interval . And I'm showing this with a smaller arrow

Â to suggest that the accrued interest is actually less than the full coupon

Â payment. On the other hand, the seller, the one

Â who decided to sell the protection on this underlying credit event, after the

Â credit event has happened at time, at the next coupon date, the seller has to pay 1

Â minus R, where R is the recovery rate, times the notional payment, N.

Â Because the buyer pays premiums, this, the premium payments are sometimes called

Â the premium leg of the CDS. And because the seller always pays the

Â amount only on default, this is also called the protection leg.

Â Here's a simple numerical example. So, consider a hypothetical 2-year CDS on

Â a notional principal N equal to $1 million.

Â And the spread S equal to 160 basis points, so just about 1.6%.

Â And lets assume that the payments are quarterly.

Â Suppose a default occurs in month 16 of a 24-month protection period.

Â And the recovery rate at that time is 45%.

Â And now, let's understand what happens to the payments of the buyers and the

Â sellers. The buyer pays premiums, so he pays

Â premiums at month 3, 6, 9, 12, and 15, and this is going to be S, the spread,

Â times the notional principal of $1 million divided by four.

Â Why? Because these are quarterly payments, so

Â it's 1 4th of a year. So, the payments in all of these months

Â is going to be $4000. Now, here's month 15.

Â The next coupon is going to be on 18. But in month 16, the default has

Â happened. So, this is the period over which the

Â interest has accrued. So, the accrued interest that I have,

Â that the buyer has to pay in month 18, is just 1 3rd of 4,000, so it's $1333.33.

Â What about the payments from the protection's seller?

Â Nothing paid up to month 15, because the default has not happened.

Â Default happens in month 16 and month 18, which is the next coupon date.

Â The seller has to pay 1 minus R times N. R was 45%, therefore, 1 minus R is 55% of

Â N, which is $550,000. This is the total protection payment.

Â Some other names for these payments. We've called them premium payments.

Â We have called them, another name for the same payment is fixed leg or the fixed

Â payments. Because the premiums are fixed, except

Â for the accrued interest amount. The name for the protection sellers

Â payment is also sometimes called a contingent leg or the contingent payment

Â because it's contingent on a default happen.

Â So, the basic model for the CDS cash flow that we're going to be using in this

Â module is what we saw in this example. There will be a faction, delta, which is

Â a fraction of a year, times k, would be the times at which the coupon payments

Â are going to happen. Delta typically is 1 quarter, that is

Â quarterly payments. And the dates of the payments are also

Â set. The March 20th, June 20th, September

Â 20th, and December 20th. If the reference entity is not in default

Â at time tk, the buyer pays the premium delta which is the fraction times S,

Â which is the spread times N which is the notional principle.

Â If the reference en, entity defaults at some time tao between tk minus 1 and tk,

Â the contract terminates at time tk. So, in the example, the default time was

Â 116. This was between the two coupon payments

Â at month 15 and month 18. The contract terminates at time 18.

Â The buyer appraised the accrued interest over whatever fraction is left over.

Â So, one month was what we did in the numerical example.

Â And the buyer receives or equally the seller pays, 1 minus R times N where R

Â denotes the recovery rate of the underlying.

Â We are going to be working with this basic model to price and understand what

Â is going to happen to the CDS sensitivities.

Â But the details behind CDSs are enormous. they have been standardized by the

Â International Swaps and Derivative Association, ISDA, in 1999.

Â There were changes made in 2003. Then again, changes were made in 2009.

Â And may yet again, changes be made, once if CDSs become exchange trader.

Â And the reason there are so many different details in a CDS contract is

Â there are many difficult issues. How does one define that a credit event

Â has occurred? was the interest payment just late, did

Â it not occur at all? It's a problem.

Â How does one determine the recovery rate? there's often litigation, there's delays

Â and so on. So, we're not going to be worrying about

Â that in this module. We are going to assume that the recovery

Â rate is somehow known. And we're going to price assuming that

Â this recovery rate is known. But also many, many details.

Â How is the spread set? How is it set for junk bonds versus

Â investment grade bonds? What about countries?

Â How is the spread set for countries? When is the coupon payment done?

Â In advance or in arrears? How is the spread quoted?

Â Is the spread quoted in terms of par spread, meaning the value that makes the

Â net value the CDS equal to 0, or some other standardized spread.

Â All these details are important when you talk about particular CDS contracts.

Â But in order to understand the basic mechanisms of how CDSs work, the basic

Â model that we have introduced is sufficient and it highlights all the main

Â features. So, we're going to focus on the basic

Â model to illustrate the details of pricing and the sensitivity to hazard

Â rates, which are the probabilities of default.

Â Later on, in the next module, I'm going to show you that the CDS spread, S is

Â approximately 1 minus R times h, here R is the recovery rate and h is the hazard

Â rate. So, for a fixed value of R, the CDS

Â spreads are directly proportional to the hazard rate h.

Â And the hazard rate is the conditional probability of default.

Â So, you will end up getting that the conditional probability of default is

Â approximately equal to S divided by 1 minus R.

Â And therefore, CDS spreads end up giving you a very good handle on the probability

Â that a particular company or a particular country, or a sovereign, is going to

Â default on the next period. So, here, just as an illustration, I'm

Â showing you what happens to the fove, what happened to the five year CDS spread

Â for Ford, GM and AIG in the first nine months of 2008.

Â The, this data up here, is all in basis points.

Â So, it started around, a thousand basis points, and it went, oh, it started

Â rising as the dates went by. And it didn't, neither of these companies

Â actually defaulted. But the probabilities of default are

Â going very high because the spreads are going high.

Â AIG went all the way up to 3500 basis points before coming back down because

Â this is where bail out event started to happen.

Â The only idea that I wanted to take away from this picture is the fact that CDS

Â spreads react to news events. AIG was very low.

Â And then, suddenly, it started to shoot up because there was feeling in the

Â market that the default is going to happen.

Â And using the formula that h is approximately equal to S divided by 1

Â minus R, we can back out what is the probability of default from the spread

Â rates. In this slide, the y axis is in

Â percentages and not in basis points. [SOUND] And it gives you a sense of the

Â credit worthiness of different countries. So, if you look at Greece, Greece, all

Â the way, went up to 25% default on around, 20, 25% spread around January

Â 12th. So, if the recovery rate is, let's say,

Â approximately 50%. Then, h, which is S divided by 1 minus R.

Â Will turn out to be, approximately a 50% default probability.

Â So, the, the market taught that the probability that Greece is going to

Â default is going to be very, very high. The next one over is Portugal, but it's

Â only at around 1.5%, which is the period over here.

Â And Germany which is exactly flat down here is pretty close to zero.

Â And so, in some sense its going to be considered the most safe or risk free of

Â the countries. Just to give you a sense of what the

Â development of the applications of CDS, I'm going to trace some of the history.

Â The development of the modern merger CDS is credited to Blythe Masters of JP

Â Morgan. It was created in 1994 to cover JP Morgan

Â for the $4.8 billion credit line that it had issued to Exxon to cover the possible

Â punitive damages in the Exxon Valdez spill.

Â So, after extending the credit line, JP Morgan protected itself by buying

Â protection from the European Bank for Reconstruction and Development using a

Â CDS. The CDS market, since then, has grown

Â tremendously. By the end of 2007, the CDS market had a

Â notional value for 62 trillion. Since then, things have become better.

Â The DTCC estimates of the gross notional amount, gross years stands for the fact

Â that after netting of, off setting CDS agreements, the notional amount in 2012

Â was about 25 trillion. So, 2007 was before the financial crisis,

Â 2012 is after the financial crisis and things have started to come down.

Â CDSs is where initially developed for hedging.

Â they allow to hedge concentrations of credit risk privately.

Â So, if, take the example of JP Morgan, Exxon.

Â JP Morgan makes a loan to Exxon. It wants to protect itself.

Â So, there are two possibilities. One, it could write the loan off to

Â somebody else, in this case, the European Bank for Reconstruction and Development.

Â But that would mean that it would have to inform Exxon that the loan has been

Â written, written to another corporation. That might affect the relationship of JP

Â Morgan and Exxon. Instead, you could construct, you could

Â create a CDS contract and effectively still remove that credit off of your

Â balance sheet. you can create, you can hedge credit

Â exposures when no publicly traded debt exists.

Â And this is because CDSs can be written on anything pretty much, and it's a

Â contract, it's not really a bond or a cash bond.

Â And therefore, you can use this construct to hedge against situations where bonds,

Â or publicly traded debt, is not available.

Â Although, CDS can be used to protect against losses, it's very different from

Â an insurance contract. It's a contract that can be returned to

Â cover anything. You can buy protection even when you

Â don't hold the underlying debt. In order to buy insurance, you have to

Â hold the underline quantity. To buy the insurance on a house, you have

Â to be the owner of the house. To buy insurance on a bond, you need to

Â hold the bond. You can buy a CDS on a bond without even

Â holding the bond. CDS is easy to create and until recently

Â completely unregulated. And because of these reasons, investing,

Â and in some cases, speculation, became the main application very soon.

Â CDS has provided an unfunded way to create credit risk.

Â So, in order to take a credit risk on a particular company, you either have to

Â take by the bond or you have to short sell the bond.

Â Now, short selling bonds is very difficult.

Â On the other hand, by writing a CDS from a particular company, you can expose

Â yourself with a credit risk. You can tailor the credit exposure to

Â match the precise requirement. This is because CDS is a contract and you

Â can precisely define the contract that you want.

Â CDS has allowed you to take view on the credit quality of the referenced credit.

Â If you think that the credit quality is going to go down, you're going to buy

Â protection. If you think that the credit quality is

Â going to go up, then you're going to sell the protection.

Â So, in both directions you can take a view, a positive view or a negative view.

Â Buying protection, which means that when you have a negative view in a market, is

Â often easier than shorting the asset. So, CDSs are became the real easy way of

Â taking negative bets on various corporations.

Â 15:21

Another way CDS has started to be used is to arbitrage between the reference bond

Â and the CDS price. It's not coupon, but a reference bond and

Â the CDS spreads, gave another opportunity to find an investment opportunity to make

Â the difference. CDSs have been blamed for the financial

Â crisis and the debt crisis. And there are many reasons why this

Â happened. CDS positions are not transparent.

Â The riskiness of financial intermediaries, therefore cannot be

Â accurately evaluated, because they don't, these positions don't show up on a

Â balance sheet. And because of that, because of the fact

Â that you could not accurately evaluate the riskiness of financial

Â intermediaries, it threatened the trust in all counter parties.

Â Since no one knew who faced losses when a crisis event happened, all the counter

Â parties were suspect and entire trading came to a halt.

Â CDS were treated on an OTC market and because of that, because impossible for

Â any dealer to know what previous deals a customer had made.

Â Resulting in situations where some dealers could make lots of CDS deals

Â without putting up enough collateral. So, AIG was able to leverage its high

Â credit rating to sell approximately $500 billion worth of CDSs, without putting up

Â the enough collateral. Because it was in the OTC market and

Â because they were, because these trades were opaque, it allowed a small number of

Â CDS traders to take on huge amounts of risk.

Â And it also allowed them to be very severely interconnected in terms of their

Â obligations. And as a result of this

Â interconnectedness, the dealers led to worries about contagion.

Â CDSs also have been blamed during the financial crisis to adversely affect the

Â cost of borrowing of a firm in a country. And recently, more so in the European

Â debt crisis, CDS have been blamed for the fact that the cost of borrowing of

Â countries have gone tremendously high. So, the story here is that speculated

Â purchase CDS, without holding the underlying debt, sometimes called a naked

Â CDS. Once a lot of these speculators actually

Â start buying these naked CDS, this drives the spread higher.

Â And when the spread goes high, because the market perceives the spread as the

Â riskiness of a particular company or a particular country, the firms start

Â appearing risky. And the cost of borrowing of the firm

Â increases. The cost of borrowing of the sovereign

Â increases. And this can lead to collapse.

Â Various policy decisions have been made in the recent past to try to correct all

Â of these problems. Try to get CDS positions and balance

Â sheets. Trying to move the CDS, at least, to a

Â clearing house. And then, to an exchange credit

Â situation. this allow naked CDSs.

Â Many of these are things that are in, in place, some of them completed, some of

Â them are still being discussed. But CDSs have played their role and will,

Â unless something is done, will continue to be a risky part of the economy.

Â