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1、FACULTY OF ECONOMICS & BUSINESSCredit Default Swaps & ReviewLecture 12 DR. ANDREW AINSWORTHFINC3019 FIXED INCOME SECURITIESLast weekInterest rate swaps-Comparative advantage-Pricing-Eurodollar futures-What are they used for?Australian swap instruments-BBSW-OISIntroductionCredit default swaps (CDS)-W
2、hat are they?-Why are they used?-PricingReading Sundaresan Ch 18Review lecture-Exam format-Content-What have we learned this semesterCredit Default SwapsCDSCDS allow one counterparty to increase their exposure to the credit risk of a given entity and the other counterparty to reduce their credit exp
3、osure-They are privately negotiated insurance contracts-They trade in an OTC marketA CDS is written over a “reference entity”-Greece, Ford, Macquarie Bank, etcProtection buyer: pays a periodic fixed fee to the protection seller until either maturity or a the occurrence of a pre-specified credit even
4、t-Effectively short the underlying obligation/reference entityProtection seller: pays compensation to the protection buyer if a pre-specified credit event occursCDS vary in their maturity from 1 to 10 years although 5 years is the most activeParticipants in the CDS marketThere has been substantial g
5、rowth in the CDS market from $3.6 trillion in 2003 to $32 trillion by 2007Banks are the main players in the market-Proprietary trading desks-Loan portfolios buying protectionHedge funds are also prominent as both buyers and sellersInsurance companies are also active sellers of protectionThe 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 eventsThe three most important credit events are:-Bankruptcy-Failure to pay outstanding debt obligations-Restructuring-Full restructuring-Modified restru
7、cturing-Double modified restructuring-No restructuring Other credit events of lesser importance-Repudiation or moratorium-Obligation acceleration-Obligation defaultSettlementContracts can be settled by physical delivery or cash settlementPhysical: protection seller purchases the distressed bond from
8、 protection 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
9、 obligation (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?Pro
10、tection 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 CDSThe notional principal generally ranges between $10m and $20mThe periodic fixed
11、 fee is referred to as the CDS spread-Dont confuse it with a yield spreadThe spread is relative to the notional principalSpread 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 t
12、o the protection sellerValuing a CDSAs with interest rate swaps, the present value of each side of the swap must be equal when the swap is entered intoThe fixed leg: buyer makes periodic payments of the CDS spreadThe contingent leg: the protection seller makes one payment if a credit event occurs-Th
13、e recovery 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:Valuing a CDSIn determining the present value of the fixed leg, we need to take account of the probability
14、that the firm will survive until that quarterly paymentFor 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 eventNote: the survival probability is 1 the probability of the firm defaulting-If you really
15、want more equations see pp. 389-390The 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 increaseThere is also an estimate of the loss given default inherent CDS pricing-This i
16、s generally assumed to be 40%CDS spreadsCDS spreadsCDS spreadsCDS spreadsCDS spreadsReview lectureTopic 1: IntroductionTypes of debt trading volume, issuance outstandingParticipantsRisks of investing in fixed income-Liquidity risk, interest rate risk, etcRisk-return historyPrimary and secondary mark
17、etsTopic 2: Bond pricingCGBs-Settlement vs quoted price and accrued interest-Integer and non-integer period to maturityZero coupon bonds, T-bills and reposMeasures of yield-Current yield-Coupons, capital gains and reinvestment income-Holding period returnRelationship between yield, price and coupon
18、rateTopic 3: Duration and convexityMeasures of bond price volatility-Price value of a basis point-Macaulay duration-Modified duration-How to immunise using durationConvexity-What does it measure?-You wont have to calculate this in the examEffective duration-Relevance for bonds with embedded optionsT
19、opic 4: Term structure of interest ratesThe 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 ra
20、tes (bootstrapping)-Forward ratesTheories of the term structure-Expectations, liquidity premiumSTRIPS market-Why would you want to hold zero coupon bonds?Topic 5: Models of the term structureEstimating the spot curve using binomial trees-Multiplicative random walk-Mean revertingSelected theoretical
21、models of the term structure-What constitutes a good model?-Properties of different models-Vasicek, CIR, Ho and LeeEffective duration revisited-Valuing a callable bond using a binomial treeTopic 6: Corporate debt and credit riskCredit risk and default-What are they?What factors affect recovery rates
22、Credit ratings agencies-What role do they play in fixed income markets?-How do they do this?-What determines credit ratings?Structural models of default-Understand the broad intuitionTopic 7: Bond portfolio managementBenchmark indices and tracking errorPassive bond portfolio management-How does a po
23、rtfolio manager achieve index returnsActive bond portfolio management-Different trading strategies used by active managers-Butterflies, riding the yield curvePerformance evaluation of bond fund managers-Are they worth the money they are paid?Topics 8 & 9: SecuritisationMortgages-Risks and cash flows
24、 (i.e. calculation question on interest payments)Securitisation-The process how does it work?-Credit enhancements-Prepayment risk: what are the models and how do they effect cash flowsGuest lecture from the David Olivan (RBA)-As you know there will be at least one question in the final exam on thisC
25、ollateralised debt obligations (CDOs)-What was their role in the financial crisis?Topic 10: Interest rate futuresForwards versus futuresU.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 futuresAustralian
26、 interest rate futures-Settlement-30-day interbank futuresTopic 11: Interest rate swapsInterest rate swaps-How are they used?-How is the swap rate determined? Risks inherent in swap contractsInterest rate swaps in Australia-BBSW-OISTopic 12: Credit default swapsWhat are they?How do they work?Should
27、you be buying bonds issued by Ford?Exam format2 hoursAttempt all questions30 MCQ-Theory and calculation questions5 short answer-Similar to mid-semester-Discussion and calculation questionsHints and tipsIve mentioned many useful hints and tips during semesterLecture notesTutorialsText books (where re
28、lvant)Ive mentioned several current market 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 examIll also post additional consultation hours on Blackboard What you should know
