1、FACULTY OF ECONOMICS&BUSINESSCredit Default Swaps&ReviewLecture 12 DR.ANDREW AINSWORTHFINC3019 FIXED INCOME SECURITIESLast week Interest rate swaps-Comparative advantage-Pricing-Eurodollar futures-What are they used for?Australian swap instruments-BBSW-OISIntroduction Credit default swaps(CDS)-What
2、are they?-Why are they used?-Pricing Reading Sundaresan Ch 18 Review lecture-Exam format-Content-What have we learned this semesterCredit Default SwapsCDS CDS allow one counterparty to increase their exposure to the credit risk of a given entity and the other counterparty to reduce their credit expo
3、sure-They are privately negotiated insurance contracts-They trade in an OTC market A CDS is written over a“reference entity”-Greece,Ford,Macquarie Bank,etc Protection buyer:pays a periodic fixed fee to the protection seller until either maturity or a the occurrence of a pre-specified credit event-Ef
4、fectively short the underlying obligation/reference entity Protection seller:pays compensation to the protection buyer if a pre-specified credit event occurs CDS vary in their maturity from 1 to 10 years although 5 years is the most activeParticipants in the CDS market There has been substantial gro
5、wth in the CDS market from$3.6 trillion in 2003 to$32 trillion by 2007 Banks are the main players in the market-Proprietary trading desks-Loan portfolios buying protection Hedge funds are also prominent as both buyers and sellers Insurance companies are also active sellers of protection The majority
6、 of reference obligations are non-sovereign(90%)-60%of the obligations are investment grade-20%of the obligations are not ratedTypes of credit events The three most important credit events are:-Bankruptcy-Failure to pay outstanding debt obligations-Restructuring-Full restructuring-Modified restructu
7、ring-Double modified restructuring-No restructuring Other credit events of lesser importance-Repudiation or moratorium-Obligation acceleration-Obligation defaultSettlement Contracts can be settled by physical delivery or cash settlement Physical:protection seller purchases the distressed bond from p
8、rotection buyer at par-Problem if the market for bond is not liquid(e.g.due to bankruptcy)-There are more CDS traded than there are underlying obligations-The buyer of the credit protection has a choice as to what debt obligation to deliver upon a credit event-There will be a cheapest to deliver obl
9、igation(bond)Cash:difference between the notional principal of CDS and value of reference obligation(on same notional principal)is paid by protection seller-One difficulty that arises is how to fairly determine the value of the reference obligationWhat happens after a credit event occurs?Protection
10、BuyerProtection SellerPar value of obligationsProtection BuyerProtection SellerA:In the absence of a credit eventCDS Premium per quarter until maturityB:If a credit event occursDefaulted obligationsValuing a CDS The notional principal generally ranges between$10m and$20m The periodic fixed fee is re
11、ferred to as the CDS spread-Dont confuse it with a yield spread The spread is relative to the notional principal Spread payments are made in quarterly instalments-A 40 basis point spread on a$10m notional principal means that the protection buyer is paying$10,000 in quarterly instalments to the prot
12、ection sellerValuing a CDS As with interest rate swaps,the present value of each side of the swap must be equal when the swap is entered into The fixed leg:buyer makes periodic payments of the CDS spread The contingent leg:the protection seller makes one payment if a credit event occurs-The recovery
13、 rate(R)is important as it determines the value of the contingent payment-Value of contingent payment=notional principal x(1-R)The value of a CDS to the protection buyer(PB)is:)()()(legfixedPVlegcontingentPVPBCDSofValueValuing a CDS In determining the present value of the fixed leg,we need to take a
14、ccount of the probability that the firm will survive until that quarterly payment For the contingent leg we need to take account of the survival probability as that will determine when the contingent payment is made after the credit event Note:the survival probability is 1 the probability of the fir
15、m defaulting-If you really want more equations see pp.389-390 The important thing to note is that there is an implicit probability of default in the pricing of a CDS contract-As the probability of default increases the CDS spread will also increase There is also an estimate of the loss given default
16、 inherent CDS pricing-This is generally assumed to be 40%CDS spreadsCDS Spread(basis points)0204060801001201401601802006/06/056/10/056/02/066/06/066/10/066/02/076/06/076/10/076/02/086/06/086/10/086/02/096/06/096/10/096/02/10AustraliaCDS spreadsCDS Spread(basis points)0501001502002503006/06/056/10/05
17、6/02/066/06/066/10/066/02/076/06/076/10/076/02/086/06/086/10/086/02/096/06/096/10/096/02/10GreeceAustraliaCDS spreadsCDS Spread(basis points)0501001502002503001/06/051/10/051/02/061/06/061/10/061/02/071/06/071/10/071/02/081/06/081/10/081/02/091/06/091/10/091/02/10GreeceAustraliaCBACDS spreadsCDS Spr
18、ead(basis points)02004006008001000120014001/06/051/10/051/02/061/06/061/10/061/02/071/06/071/10/071/02/081/06/081/10/081/02/091/06/091/10/091/02/10Macquarie BankCDS spreadsCDS Spread(basis points)0200040006000800010000120003/06/053/10/053/02/063/06/063/10/063/02/073/06/073/10/073/02/083/06/083/10/08
19、3/02/093/06/093/10/093/02/10Ford MotorsReview lectureTopic 1:Introduction Types of debt trading volume,issuance outstanding Participants Risks of investing in fixed income-Liquidity risk,interest rate risk,etc Risk-return history Primary and secondary marketsTopic 2:Bond pricing CGBs-Settlement vs q
20、uoted price and accrued interest-Integer and non-integer period to maturity Zero coupon bonds,T-bills and repos Measures of yield-Current yield-Coupons,capital gains and reinvestment income-Holding period return Relationship between yield,price and coupon rateTopic 3:Duration and convexity Measures
21、of bond price volatility-Price value of a basis point-Macaulay duration-Modified duration-How to immunise using duration Convexity-What does it measure?-You wont have to calculate this in the exam Effective duration-Relevance for bonds with embedded optionsTopic 4:Term structure of interest rates Th
22、e yield curve-What are some issues in selecting U.S.Treasury securities to plot the yield curve-Factors affecting the yield curve(Litterman and Schenkman)-Economic news and bond prices(Balduzzi,Elton and Green)The term structure of interest rates-Spot rates(bootstrapping)-Forward rates Theories of t
23、he term structure-Expectations,liquidity premium STRIPS market-Why would you want to hold zero coupon bonds?Topic 5:Models of the term structure Estimating the spot curve using binomial trees-Multiplicative random walk-Mean reverting Selected theoretical models of the term structure-What constitutes
24、 a good model?-Properties of different models-Vasicek,CIR,Ho and Lee Effective duration revisited-Valuing a callable bond using a binomial treeTopic 6:Corporate debt and credit risk Credit risk and default-What are they?What factors affect recovery rates Credit ratings agencies-What role do they pla
25、y in fixed income markets?-How do they do this?-What determines credit ratings?Structural models of default-Understand the broad intuitionTopic 7:Bond portfolio management Benchmark indices and tracking error Passive bond portfolio management-How does a portfolio manager achieve index returns Active
26、 bond portfolio management-Different trading strategies used by active managers-Butterflies,riding the yield curve Performance evaluation of bond fund managers-Are they worth the money they are paid?Topics 8&9:Securitisation Mortgages-Risks and cash flows(i.e.calculation question on interest payment
27、s)Securitisation-The process how does it work?-Credit enhancements-Prepayment risk:what are the models and how do they effect cash flows Guest lecture from the David Olivan(RBA)-As you know there will be at least one question in the final exam on this Collateralised debt obligations(CDOs)-What was t
28、heir role in the financial crisis?Topic 10:Interest rate futures Forwards versus futures U.S.Treasury futures-What are the delivery options-What is basis,cost of carry and basis after carry?How do they relate to arbitrage?Eurodollar futures Australian interest rate futures-Settlement-30-day interban
29、k futuresTopic 11:Interest rate swaps Interest rate swaps-How are they used?-How is the swap rate determined?Risks inherent in swap contracts Interest rate swaps in Australia-BBSW-OISTopic 12:Credit default swaps What are they?How do they work?Should you be buying bonds issued by Ford?Exam format 2
30、hours Attempt all questions 30 MCQ-Theory and calculation questions 5 short answer-Similar to mid-semester-Discussion and calculation questionsHints and tips Ive mentioned many useful hints and tips during semester Lecture notes Tutorials Text books(where relvant)Ive mentioned several current market
31、 developments relevant for the course throughout the semester-These are examinable to the extent they were discussed in class-See material posted in the Additional Resources folder(that was discussed in lectures)Ill put some practice exam questions up on Blackboard before the exam Ill also post additional consultation hours on Blackboard What you should know
