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CREDIT DEFAULT SWAP PRICING A PREMIERE

Credit Default Swap Pricing A Premiere

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Prepared By DAVID STEINBERG Portfolio Manager | Capital Structure Arbitrage Portfolio

Carnegie Hall Tower | 152 West 57th Street | 4th Floor | New York, NY 10019

Q: What is a Credit Default Swap? A: CDS is a contract that obligates the protection seller to compensate the protection buyer for Introduction losses that will incur as a result of a credit Event in the reference obligation.

Similar to an insurance policy on a house; if the house burns down, the seller of the insurance policy is obligated to compensate the buyer of the policy for the losses he incurred as a result of the fire to the underlying asset.
Credit Default Swap Pricing A Premiere

Cash Flows The protection buyer pays the seller an annual premium in addition to an upfront fee. In return, the protection seller unconditionally guarantees to compensate the buyer for any losses he incurs due to a credit event in the reference obligation.

Credit Default Swap Pricing A Premiere

A reference obligation is a specific debt or loan of a company that will be due in the future. This can be Reference Obligation a corporate bond or bank loan of a company. All CDS contracts specify a specific debt obligation of a company for which a credit event has to occur in order for the protection seller to be obligated to make good on his guarantee.
Credit Default Swap Pricing A Premiere

A credit event occurs when a company fails to make Credit Event scheduled payments on the reference obligation. This includes scheduled interest and/or principle payments. When a company misses a scheduled payment of a debt obligation, the company is usually forced into bankruptcy by its lenders.

Credit Default Swap Pricing A Premiere

Once a credit event occurs, the protection seller is obligated to compensate Protection Paymentthe buyer for all losses that the buyer incurred on the reference obligation as a result of the credit event. This means that since debt obligations are typically worth something even in bankruptcy, the protection seller only needs to compensate the buyer for the LOSS in value of the reference obligation.
Credit Default Swap Pricing A Premiere

Once a credit event occurs, the protection Two More Points buyer ceases to make the annual premium payments. 2. However, the protection buyer must make a final premium payment for any accrued time from the previous premium payment until the credit event.
1.
Credit Default Swap Pricing A Premiere

CDS Contract Details

Contract Maintenance
So long as there is no credit event, Investor A will continue to pay the annual premium of $100,000

Credit Event
If Ford Motors Credit fails to make scheduled payments on the reference obligation, a credit event is declared

Illustration
Investor A buys a 5 year CDS on $10MM from Bank B on Ford Motor Credit Co.

Reference Obligation: Ford Motors Bond; F 12 2015 CUSIP: 345397VH3

The CDS expires at the stated maturity, in this case 5 years. Investor A makes his final premium payment and the CDS contract expires.

Bank B must compensate Investor A for any losses the Investor incurred as a result of the credit event

Investor A pays 100bps of notional value annually or $100,000.00

If, for example, the reference obligation is valued at 40 cents on the dollar in bankruptcy, then Bank B must compensate for the missing 60 cents In our example of a $10MM CDS contract, Bank B would be obligated to pay $6MM to Investor A. This is the Protection Payment.

Additionally, Investor A must pay an upfront fee to Bank B. The Upfront Fee and the annual premiums make up the Premium Payments.

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Without a Credit Event

Premium Payments

After a Credit Event

Protection Payment
Protection Payment = Notional Amount of CDS Contract Recovery Rate of Reference Obligation
Subtracted by any accrued premium due to the seller from the previous premium payment until the credit event

Cash Flow Chart

Upfront Fee
Year #1: Annual Premium of 100bps of CDS contract
Year #2: Annual Premium of 100bps of CDS contract Year #3: Annual Premium of 100bps of CDS contract Year #4: Annual Premium of 100bps of CDS contract Year #5: Annual Premium of 100bps of CDS contract

Credit Default Swap Pricing A Premiere

To arrive at an accurate market price for a CDS contract

We need to understand

CDS

Pricing Model

The value of the guarantee to compensate the protection buyer

in the event of a default.

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Credit Default Swap Pricing A Premiere

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In an efficient market place, the amount investors will pay for a security, is only what they believe is toValue be its net present value. Net Present Solving for NPV requires three steps

Knowing all possible cash flows Determining the probability of receiving each cash flow Discounting each cash flow to adjust for the time value of money; at an appropriate discount rate for each cash flow

Credit Default Swap Pricing A Premiere

Net

Present

Value

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In our example, Investor A will only pay for Bank Bs guarantee the equivalent of the guarantee's NPV. Solving for the NPV of the Protection payment For our 5yr CDS for 10MM on Ford Motors, there is a possibility of receiving requires three steps Knowing all a protection payment in each of the 5 years. Assuming a 40% recovery rate

possible cash flows

on the reference obligation after the credit event, the Protection Payment will be $6,000,000.00. Historically, IG companies bonds have a 40% RR.

Determining the probability of receiving each cash flow Discounting each cash flow to adjust for the time value of money

Here we need to decide on the probability of Ford missing a debt payment in any of the five years , thereby triggering the $6MM cash flow. This in the only input that is subjective and will vary from dealer to dealer

Accepted practice in the CDS market is to discount each cash flow by its corresponding Interest Rate Swap Rate. Standard practice is to use yesterdays end of day rates. The IR Swap Curve for CDS is published daily, and can be found on the Bloomberg at YCSW0260 Index <GO>

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Knowing all possible cash flows

Year 1 Year 2 Year 3 Year 4

Standard Notional CDS Protection Recovery Contract Rate for IG Payment Amount For our 5yr CDS for 10MM on Ford Bonds Motors, there is a possibility of receiving a protection payment in each of the 5 years. Assuming a 40% recovery rate
on the reference obligation after the credit event, the Protection Payment will be $6,000,000.00. Historically, IG companies bonds have a 40% RR.

Net Possible Cash Flow from Protection Payment

$6,000,000 $6,000,000 $6,000,000 $6,000,000

$10,000,000 $10,000,000 $10,000,000 $10,000,000

40% 40% 40% 40%

=$10MM * (1- .40)

=$10MM * (1- .40)

=$10MM * (1- .40) =$10MM * (1- .40)

Year 5

$10,000,000

40%

=$10MM * (1- .40)

$6,000,000

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The probability of a company missing a scheduled debt payment depends on many factors The total amount of current and long liabilities that are coming due The cash flow from operations of the company Determining Here we need to decide on the probability of Ford missing a debt the payment in any and of the five yearsequivalent , thereby triggering the $6MM cash probability The amount of cash cash securities a company has on its flow. This in the only input that is subjective and will vary from dealer of receiving to dealer sheet each cashbalance flow Investors can look at the Yield to Maturity of a companys bonds to gain insight on the markets view of the credit worthiness of a company. In all, this aspect of the CDS Pricing Model is the only input that is somewhat subjective and can vary from dealer to dealer. (However, the level of variance in this input cannot be that large, as that would present, what is know as a Basis Arbitrage trade.) For the purpose of this presentation, we will use the default probabilities found on the VCDS <GO> page on the Bloomberg for the Ford Motors Bond.
Credit Default Swap Pricing A Premiere

Determining the probability of receiving each cash flow 16

Here we need to decide on the probability of Ford missing a debt payment in any of the five years , thereby triggering the $6MM cash flow. This in the only input that is subjective and will vary from dealer to dealer

We can see the Default Probability for the next month through the year 2020.

For our 5yr CDS, we only need the probability of default for next 5 years.

Credit Default Swap Pricing A Premiere

Determining the probability of receiving each cash flow

Here we need to decide on the probability of Ford missing a debt payment in any of the five years , thereby triggering the $6MM cash flow. This in the only input that is subjective and will vary from dealer to dealer

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Net Possible Cash Flow from Protection Payment

Year 1 Year 2 Year 3 Year 4 Year 5 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000

Default Probability

Default Probability per Period

0.05290 0.06020 0.05080 0.05750 0.05190

Probability Adjusted Cash Flow

$317,400 $361,200 $304,800 $345,000 $311,400

0.0529 0.1131 0.1639 0.2214 0.2733

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The third step in solving for the NPV of the protection payment is to discount each of the probability adjusted cash flows to their present value. CDS market use the USD SWAP Curve to Discounting each conventions Accepted practice in the CDS market IR is to discount each cash flow by itsdiscount each cash cash flow to adjust corresponding Interest Rate Swap Rate. Standard practice is to use flow. for the time value yesterdays end of day rates. The IR Swap Curve for CDS is published
of money daily, and can be found on the Bloomberg at YCSW0260 Index <GO>

Each cash flow occurs in a different period, and therefore needs to be discounted to using the periods corresponding SWAP rate in the IR SWAP Curve. Meaning, the cash flow occurring at the end of year one needs to be discounted by the 1yr SWAP rate, the cash flow occurring at the end of year two will be discounted by the 2yr SWAP Rate, and so on.

To avoid the intraday volatility in the IR SWAP Rate market, CDS market conventions use the previous days end of day rate.
The IR SWAP curve rates for CDS can be found on the Bloomberg at YCSW0260 Index <GO>
Credit Default Swap Pricing A Premiere

USD ISDA CDS SWAP Curve

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The Description page for the USD ISDA CDS SWAP Curve Type:

YCSW0260 Index DES <GO>

Credit Default Swap Pricing A Premiere

USD ISDA CDS SWAP Curve

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Credit Default Swap Pricing A Premiere

Discounting each cash flow to adjust for the time value of money

Accepted practice in the CDS market is to discount each cash flow by its corresponding Interest Rate Swap Rate. Standard practice is to use yesterdays end of day rates. The IR Swap Curve for CDS is published daily, and can be found on the Bloomberg at YCSW0260 Index <GO>

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The mathematics for discounting at different discount rates for each period varies fv from the typical PV formula of pv 1 rate period Instead, the PV of a cash flow combining different discount rates is calculated by creating a discount factor. The discount factor is just another way of expressing the present value of $1.00 received at period X, using multiple discount rates.

$1.00 For the first period, the discount factor resembles the typical PV formula; 1 cr when is the corresponding rate on the IR SWAP Curve.
FV
2

cr ,

For the second period, instead PV of 1 rate , which uses one rate for all periods, we need an equation that will capture the different rates for each corresponding period on the IR SWAP Curve. The exact equivalent to the typical PV formula, but $1.00 that also takes into accountdf thedifferent rates, is
p2

(1 crp1 )(1 crp 2 )

Credit Default Swap Pricing A Premiere

Discounting each cash flow to adjust for the time value of money

Accepted practice in the CDS market is to discount each cash flow by its corresponding Interest Rate Swap Rate. Standard practice is to use yesterdays end of day rates. The IR Swap Curve for CDS is published daily, and can be found on the Bloomberg at YCSW0260 Index <GO>

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df Discount factor for period two;
p2

$1.00 (1 crp1 )(1 crp 2 )

Where; df = discount factor for period 2 (cr ) = corresponding rate from period 1 (cr ) = corresponding rate from period 2
p2 p1 p2

For period three the discount factor simply adds the corresponding rate to the $1.00 denominator;df
p3

(1 crp1 )(1 crp 2 )(1 crp 3 )

For each of the remaining periods we construct a discount factor by simply adding the new periods corresponding rate to the denominator.
df Discount factor for period four; df Discount factor for period five;
p4

$1.00 (1 crp1 )(1 crp 2 )(1 crp 3 )(1 crp 4 ) $1.00 (1 crp1 )(1 crp 2 )(1 crp 3 )(1 crp 4 )(1 crp 5 )

p5

Credit Default Swap Pricing A Premiere

Determining the probability of receiving each cash flow

Here we need to decide on the probability of Ford missing a debt payment in any of the five years , thereby triggering the $6MM cash flow. This in the only input that is subjective and will vary from dealer to dealer

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Probability Adjusted Cash Flow

Corresponding Rate from USD ISDA IR SWAP Curve

Discount Factor

pv of Protection Payment

Year 1 Year 2 Year 3 Year 4 Year 5

$317,400 $361,200 $304,800 $345,000 $311,400

.8938 % 1.250 % 1.7951 % 2.2875 % 2.7095 %

0.99114 0.97934 0.96207 0.94055 0.91574

$314,588 $353,738 $293,239 $324,491 $285,162

Credit Default Swap Pricing A Premiere

NVP of Protection Leg

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Probability Adjusted Cash Flow

Corresponding Rate from Discount Factor USD ISDA IR SWAP Curve Summing these discounted cash flows

pv of Protection Payment

will give us the NPV = $1,571,218.52

Year 1 Year 2 Year 3 Year 4 Year 5

$317,400

.8938 %

0.99114

$314,588

We now know the value, or NPV, of the sellers guarantee the 1.250 % to reimburse 0.97934 $353,738 $361,200 buyer for any loss resulting from a credit event. 1.7951 % $304,800 0.96207 $293,239 This amount is what will be $345,000 2.2875 % the buyer 0.94055
willing to pay for the guarantee, and is the market value for this CDS contract.

$324,491 $285,162

$311,400

2.7095 %

0.91574

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We now know the amount the protection buyer will have to pay to buy this CDS from the seller. As we mentioned in the outset, the buyer does not pay for the CDS in one lump sum, but rather the payments consist of annual premiums of 100bps of the notional CDS amount, and one upfront payment. In other words, some of the money owed to the seller is paid annually for the duration of the contract, and some is paid upfront.

Valuing the Premium Payments

Due to standard CDS contract conventions, we always know that the annual payments will be 100bps of the CDS notional amount. The only remaining question is the amount of the upfront payment. To solve for the upfront amount due to the seller, we will discount the annual premium payments , as well as any accrued premiums that may be due if a credit event occurs in between premium payments. The NPV of the possible premium payments plus the upfront premium must equal the market value, or Credit Default Swap Pricing A Premiere the NPV of the protection payment.

Solving for the premium upfront amount

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In our example, we know the market value of the protection payment is $1,571,218.52. This is the amount the buyer will need to pay to receive the protection guarantee, and the NPV of all the buyers payments will need to equal $1,571,218.52. By CDS market conventions the buyer will make annual premium payments of 100bps of 10MM notional or $100,000 annually for 5 years or until a credit event occurs. Additionally, the buyer will have to pay any accrued premium if a credit event occurs in between scheduled premium payments. To arrive at the NPV of these cash flows we will again have to take into account the probability of the buyer having to make these payments, i.e. the probability of survival, and then discount each cash flow by its corresponding rate on the ISDA USD IR Swap. The difference between the NPV of the buyers annual premium payments and NPV of the sellers protection payment will be the amount the buyer will need to Credit Default Swap Pricing A Premiere make in the upfront payment.

Probability Adjusted Annual Premium

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Annual Premium Payment

Default Probability

Survival Probability (1-default prob)

Probability Adjusted Cash Flow

Just as we adjusted the cash flows of the protection payment by the probability of Year 1 $100,000 $94,710 receiving them, we will do the same 0.0529 for the premium 0.94710 payments. The buyer will make these annual payments for as long as the company survives, so the 1 default probabilit y is simply probability cash flows Year 2 of these $100,000 0.1131 0.88690 $88,690

Year 3 Year 4 Year 5

$100,000 $100,000 $100,000

0.1639 0.2214 0.2733

0.83610 0.77860 0.72670

$83,610 $77,860 $72,670

Credit Default Swap Pricing A Premiere

Probability Adjusted Accrued Premium

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Probability NET Default Besides the scheduled annual premium, we must also account for the possibility Accrued Adjusted Probability Probability that the buyer will Premium have to pay accrued premium if a Accrued credit event occurs in Adjusted per Period between annual payments. Cash Flow Cash Flow
1 that if a$50,000 0.05290 $2,645.00 $97,355.00 We Year assume credit event occurs, it will happen exactly half way through the payment period, therefore the buyer will have to pay for half the period or in our Year case2$50,000. $50,000 0.06020 $3,010.00 $91,700.00

Of course, payments are only made if the company defaults, so the Year 3 accrued $50,000 0.05080 $2,540.00 $86,150.00 probability of receiving any accrued payments is the same as the default probability for the period.
Year 4 Year 5 $50,000 $50,000 0.05750 0.05190 $2,875.00 $2,595.00 $80,735.00 $75,265.00

Credit Default Swap Pricing A Premiere

Discounting all Premium Payments

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NET pv of Probability Annual df Adjusted Premium Cash Flow Payments Next we need to discount each probability adjusted cash flows by the
corresponding rate of the ISDA USD IR Swap.

Year 1

$97,355

0.99114

$96,493

As we did with the protection payment, we will formulate a discount factor for each period. Year 2 $91,700 0.97934 $89,805

Year 3 Year 4

$86,150 $80,735

0.96207 0.94055

$82,882 $75,936

NPV =

$414,039.44

Year 5

$75,265

0.91574

$68,923

Credit Default Swap Pricing A Premiere

Solving for the premium upfront amount

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NET NPV of Protection Probability Payment df Adjusted = $1,571,218.52 Cash Flow

pv of Remaining premium due to Annual seller upfront Premium = $1,157,179.07 Payments

Year 1

$97,355

0.99114

$96,493

Year 2
Year 3 Year 4

$91,700
$86,150 $80,735

0.97934
0.96207 0.94055

$89,805
$82,882 $75,936
NPV of Annual Premium Payments =

$414,039.44

Year 5

$75,265

0.91574

$68,923

Credit Default Swap Pricing A Premiere

The Equation
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NPV of Annual Premium Payments =

NPV of Protection Payment

= $1,571,218.52

$414,039.44

Remaining premium due to seller upfront = $1,157,179.07

In other words the upfront premium payment is simply;

NPV protection payment NPVscheduled accrued premium payments upfront premium

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The mathematically stated equation for CDS is;

The CDS Equation

S (t ) DF (t ) P D(t
i 1 i i
NPV scheduled premium payments

NPV of all premium payments

i 1

NPV of protection payment

n

ti ) DF (ti )( P / 2) (1 R) D(ti 1 ti ) DF (ti )

i 1
NPV accrued premium payments

Where;
S (ti )
DF (ti )

P
D (ti 1 ti )

= Survival probability for period t = Discount factor for period t = Premium payment = Default probability for period t, but not before period t = Recovery rate on reference obligation

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CDS Notional Recovery Rate Annual Premium Rate Present Value of Protection Payment Protection P Payment 1 $ 6,000,000.00 2 6,000,000.00 3 6,000,000.00 4 6,000,000.00 5 6,000,000.00 10,000,000 40.00% 1.000% Default Default Probability Probability for Period 5.290% 0.05290 11.310% 0.06020 16.390% 0.05080 22.140% 0.05750 27.330% 0.05190 Probability Adjusted CF 317,400.00 361,200.00 304,800.00 345,000.00 311,400.00

The Spreadsheet

cr 0.8938% 1.2050% 1.7951% 2.2875% 2.7095%

df 0.99114 $ 0.97934 0.96207 0.94055 0.91574 NPV

pv 314,588.21 353,737.66 293,238.94 324,491.41 285,162.30

$ 1,571,218.52

Present Value of Premium Payment p Premium Payment 1 $ 100,000.00 2 100,000.00 3 100,000.00 4 100,000.00 5 100,000.00 Survival Probability Probability Adjusted CF 94.71% $ 94,710.00 88.69% 88,690.00 83.61% 83,610.00 77.86% 77,860.00 72.67% 72,670.00 Accrued 50,000.00 50,000.00 50,000.00 50,000.00 50,000.00 Probability Adjusted Accrued CF $ 2,645.00 3,010.00 2,540.00 2,875.00 2,595.00 df 0.99114 $ 0.97934 0.96207 0.94055 0.91574 NPV $ pv 96,492.55 89,805.49 82,882.33 75,935.69 68,923.38 414,039.44

Credit Default Swap Pricing A Premiere

NPV of CDS Contract

1,157,179.07

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Credit Default Swap Pricing A Premiere