Credit Default Swap Valuation Explained
HedgeStar performs credit default swap valuations on a periodic basis depending on client requirements. We can also value credit default swaps on a historical basis for clients needing to look back to see where a particular credit traded.
Calculating the gain or loss from a credit default swap position is not as simple as calculating the difference between the current market price and the purchase price. The term structure of default swap spreads is used along with market standard recovery rates. All calculations are performed using discounted cash flow models. Credit default swaps have two legs, a protection leg and a premium leg. The premium leg is a constant payment that is paid by the protection buyer for the life of the contract. The protection leg is a contingent leg, and applies if a credit event occurs. Credit events are defined in the transaction documentation.
Credit Default Swap Description
A credit default swap (CDS) is an agreement to exchange payments based on an underlying credit or underlying basket of credits. Essentially a CDS is a form of insurance policy against a credit event occurring. One party is buying protection and the other is selling protection. The buyer pays a series of payments to the seller and the seller agrees to reimburse the buyer if losses occur due to certain credit events. Single name credit default swaps are usually tied to or reference a specific bond or loan. For example, the holder of a corporate bond issued by ABC corporation may wish to protect itself against the risk of the bond defaulting. It can purchase credit protection for a fee (spread) and the seller of the protection would be required to honor the terms of the specific arrangement.
A single name CDS is one that is based on a specific company’s debt while a basket CDS takes on the characteristics of the unique basket that is established by the originator of the basket. Basket CDS are used to hedge market credit spreads while single name CDS are used to hedge specific bond investments or loans.
Credit default swaps can be physical settlement or cash settlement. In a physical settlement, the protection buyer delivers the defaulted bond to the protection seller in exchange for the agreed upon loss calculation (the settlement payment). Sometimes the specific bond is identified in the transaction confirmation and other times a general description of the bond is given, and the protection buyer can deliver any bond that meets the general characteristics. Cash settlement does not require delivery of the physical bond but a net payment due to the protection purchaser based on market standard terms.
Terms of a Typical Credit Default Swap
Credit default swaps have become more standardized over time. Typically a CDS will be documented using International Swaps and Derivatives Association (ISDA) standard documentation which includes a master agreement, schedule, credit support annex and confirmation. As the market moves from primarily over-the-counter to exchange traded, the documentation becomes easier to manage. The schedule and credit support annex provide the credit terms and other business terms between the protection buyer and seller.
A CDS confirmation provides all the details of the specific transaction including the notional amount, maturity date, payment dates, payment terms, credit events, reference security information and reference entity. One of the important terms of the CDS confirmation is the definition of the credit event or events. This is critical to the value of the protection. A credit event will require payment by the protection seller to the protection buyer. Bankruptcy and failure to pay (default) are typical credit events.
The confirmation will also indicate whether or not the contract is to be physically settled (by delivery of the reference obligation from the protection buyer to the protection seller) or cash settled (rather than a physical delivery, the protection buyer receives a net cash payment equal to the principal amount protected less the expected recovery amount). The confirm will also define the deliverable obligation or reference obligation. This can be a specific security or more generally described as securities that meet certain characteristics such as “a senior secured bond issued by the reference entity that matures on or after” a specific date.
Valuation of Credit Default Swaps
Credit default swaps are not as simple to value as other derivative instruments. The model must take into account the term structure of default swap spreads as well as the recovery assumption. The recovery rate is defined as the amount that the holder of the protected instrument would expect to receive in the event of a default. The corporate bond market uses a 40% recovery rate as a standard and the municipal market uses an 80% recovery rate. Of course, each individual transaction can be negotiated (if the over-the-counter market is used) between the parties.
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