READING 52.

CREDIT DEFAULT SWAPS (Old Reading 56)

The candidate should be able to:
a. describe credit default swaps (CDS), single-name and index CDS, and the
parameters that define a given CDS product;
b. describe credit events and settlement protocols with respect to CDS;
c. explain the principles underlying, and factors that influence, the market’s
pricing of CDS;
d. describe the use of CDS to manage credit exposures and to express views
regarding changes in shape and/or level of the credit curve;
e. describe the use of CDS to take advantage of valuation differences among
separate markets, such as bonds, loans, and equities.
EXAMPLE 1, Page-345, Cheapest-to-Deliver bligation
Assume that a company with several debt issues trading in the market files for
bankruptcy (i.e., a credit event takes place). What is the cheapest-to-deliver
obligation for a senior CDS contract?
A. A subordinated unsecured bond trading at 20% of par
B. A five-year senior unsecured bond trading at 50% of par
C. A two-year senior unsecured bond trading at 45% of par
EXAMPLE 2, Page-350, Settlement Preference
A French company files for bankruptcy, triggering various CDS contracts. It has two
series of senior bonds outstanding: Bond A trades at 30% of par, and Bond B trades
at 40% of par. Investor X owns €10 million of Bond A and owns €10 million of CDS
protection. Investor Y owns €10 million of Bond B and owns €10 million of CDS
protection.
1. Determine the recovery rate for both CDS contracts.
2. Explain whether Investor X would prefer to cash settle or physically settle her
CDS contract or whether she is indifferent.

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3. Explain whether Investor Y would prefer to cash settle or physically settle his
CDS contract or whether he is indifferent.
EXAMPLE 3, Page-351, Hedging and Exposure Using Index CDS
Assume that an investor sells $500 million of protection on the CDX IG index.
Concerned about the creditworthiness of a few of the components, the investor
hedges a portion of the credit risk in each. For Company A, he purchases $3 mil-
lion of single-name CDS protection, and Company A subsequently defaults.
1. What is the investor’s net notional exposure to Company A?
2. What proportion of his exposure to Company A has he hedged?
3. What is the remaining notional on his index CDS trade?
EXAMPLE 4, Page-356, Hazard Rate and Probability of Survival
Assume that a company’s hazard rate is a constant 8% per year, or 2% per quarter.
An investor sells five-year CDS protection on the company with the premiums paid
quarterly over the next five years.
What is the probability of survival for the first quarter?
What is the conditional probability of survival for the second quarter?
What is the probability of survival through the second quarter?
EXAMPLE 5, Page-358, Change in Credit Curve
A company’s 5-year CDS trades at a credit spread of 300 bps, and its 10-year
CDS trades at a credit spread of 500 bps.
1. The company’s 5-year spread is unchanged, but the 10-year spread widens by 100 bps.
Describe the implication of this change in the credit curve.
2. The company’s 10-year spread is unchanged, but the 5-year spread widens
by 500 bps.
Describe the implication of this change in the credit curve.
EXAMPLE 6, Page-359, Premiums and Credit Spreads
1. Assume a high-yield company’s 10-year credit spread is 600 bps, and the
duration of the CDS is eight years. What is the approximate upfront premium
required to buy 10-year CDS protection? Assume high-yield companies have
5% coupons on their CDS.
2. Imagine an investor sold five-year protection on an investment-grade
company and had to pay a 2% upfront premium to the buyer of protec- tion.
Assume the duration of the CDS to be four years. What are the company’s
credit spreads and the price of the CDS per 100 par?
EXAMPLE 7, Page-361, Profit and Loss from Change in
Credit Spread
An investor buys $10 million of five-year CDS protection, and the CDS contract has
a duration of four years. The company’s credit spread was originally 500 bps and
widens to 800 bps.
1. Does the investor (credit protection buyer) benefit or lose from the change in
credit spread?
2. Estimate the CDS price change and estimated profit to the investor.

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EXAMPLE 8, Page-365, Curve Trading
An investor owns some intermediate-term bonds issued by a company and has
become concerned about the risk of a near-term default, although he is not very
concerned about a default in the long term. The company’s two-year duration CDS
currently trades at 350 bps, and the four-year duration CDS is at 600 bps.
1. Describe a potential curve trade that the investor could use to hedge
the default risk.
2. Explain why an investor may prefer to use a curve trade as a hedge against
the company’s default risk rather than a straight short position in one CDS.
EXAMPLE 9, Page-366, Bonds vs. Credit Default Swaps
An investor wants to be long the credit risk of a given company. The company’s
bond currently yields 6% and matures in five years. A comparable five-year CDS
contract has a credit spread of
3.25%. The investor can borrow in the market at a 2.5%
interest rate.
1. Calculate the bond’s credit spread.
2. Identify a basis trade that would exploit the current situation.
EXAMPLE 10, Page-367, Using CDS to Trade on a Leveraged Buyout
An investor believes that a company will undergo a leveraged buyout (LBO)
transaction, whereby it will issue large amounts of debt and use the proceeds to
repurchase all of the publicly traded equity, leaving the company owned by
management and a few insiders.
1. Why might the CDS spread change?
2. What equity-versus-credit trade might an investor execute in anticipation of
such a corporate action

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