final ppt cds anamika handique iipm fn5

CONCEPT OF CREDIT DEFAULT SWAPS

SUBMITTED TO:-

PROF. AMIT BAGGA

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CREDIT DEFAULT SWAPS (CDS)April 11, 2023 CREDIT DEFAULT SWAPS

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History

Credit defaults swaps were invented in 1997 by a team working for JP Morgan Chase.

They were designed to shift the risk of default to a third party so that it become less punitive and largely exempt from regulatory ACTs.

The market size for CDS began to grow rapidly from 2003,by late 2007 it was ten times as large as it had been four years previously.

Credit defaults swaps are by far the most widely traded credit derivatives product.

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CREDIT DEFAULT SWAPS

A credit default swap (CDS) is a credit derivative contract between two counterparties.

Buyer Seller

April 11, 2023 CREDIT DEFAULT SWAPS

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Understanding

Credit default swap is a swap contract between two counterparties in which the buyer of the CDS makes a series of payments (premiums) to the seller and in exchange receives a payoff if a credit instrument goes into default (fails to pay).

The security being insured in known as “Reference Entity”

Credit event that triggers the pay off can be company undergoing restructuring, bankruptcy , or even just having a credit rating downgraded ..

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As an example, imagine that an investor buys a CDS from CITI Bank, where the reference entity is AIG Corp. The investor will make regular payments to CITI Bank, and if AIG Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-off payment from CITI Bank and the CDS contract is terminated.

· Credit default swap can be bought by any investor it is not necessary for the buyer to own the credit instruments. ( Like in the above case the investors can also buy CDS contracts referencing AIG Corp debt, without actually owning any AIG Corp debt. )

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The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount.

A CDS contract is typically documented under the term of

confirmation which is published in international swaps and derivatives association .

The period over which default protection extends is defined by the contract effective date and scheduled termination date

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CDS confirmation also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer.

· This market is basically unregulated and being that there is no transparency as to who is on the other side of the transaction, it can become very risky when it comes to fulfill the seller obligation.

· Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have even been claims that CDSs led the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.

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USES OF CDS

Speculation:-speculate on changes in an entity's credit quality.

Hedging:-Credit default swaps are often used to manage the credit risk (i.e. the risk of default) which arises from holding debt.

Arbitrage:-When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk.


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Differences between insurance and CDS

The seller need not be a regulated entity.

In CDS payment upon settlement that may be more than

the loss (if any) suffered by the buyer.

The buyer of a CDS does not need to own the underlying security or other form of credit exposure


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Pricing and valuation

There are two competing theories usually advanced for the pricing of credit defaults swaps

Probability model No-arbitrage approach probability model takes the present value of series of cash flows

weighted by their probability of non default. Probability model method suggests that credit defaults swaps should

trade at a considerably lower spread than corporate bonds. In second model proposed by darrell duffie hull and white do not

consider arbitrage concept. In probability model where as cds is priced by considering four inputs- Issue premium Recovery rate Credit curve LIBOR curve


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Risk in cds

The buyer takes the risk that the seller will default.

The seller takes the risk that the buyer will default on the contract.

The seller normally limits its risk by buying offsetting protection from another party that is ,it hedges its exposure.

If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party.


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SETTLEMENT OF CDS

There are two methods through which contract of cds can be settledown. physical settlement cash settlement In physical settlement the protection seller pays the buyer par value, and in

return takes delivery of a debt obligation of the reference entity.

In cash settlement the protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity.

In the settlement of CDS the trade confirmation produced when a CDS is traded will state whether the contract is to be physically or cash settled.


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CONTD… When a credit event occurs on a major company on which a lot of CDS

contract are written ,an auction mye be held to facilitate settlement of a large number of contract at once at a fixed cash settlement price.

The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled.

Auction is organized by international swaps and derivatives association. The process of auction have recently proved an effective way of settling

very large volume of outstanding CDS contracts like Lehman Brothers and Washington Mutual.


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Regulatory change over cds

The introduction of central clearing houses which act as the central counterparty to both sides of a CDS transaction, there by reducing the counterparty risk that both buyer and seller face.

The international standardization of CDS contracts to prevent legal disputes in ambiguous cases where its not clear what the payout should be.


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CRITICISM OF CDS

All CDS contracts are privately negotiated so that market has no transparency.

Warren Buffett famously described credit derivatives bought speculatively as “financial weapons of mass destruction”


LEHMAN BROTHERS HOLDINGS INC. BANKRUPTCY

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Henry Lehman, Emanuel Lehman & Mayer Lehman are its founders

Headquarters : New York City, New York, UNITED STATES

Type : Public

Fourth largest US investment BANK


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WHAT WAS LEHMAN BROTHERS?

A 158 yr old GLOBAL FINANCIAL SERVICES FIRM

Did business in:- Investment banking Equity Fixed income sales Research & trading Private Banking


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WHAT HAPPENED? Since CDS spread simply reflect the reality that the company is in serious

trouble.

In Lehman Brothers case due to this widened CDS spread bank has lost the confidence in the market.

CDS market allowed investors who had counterparty risk with Lehman brothers to reduce their exposure in the case of their default.

The $400 billion notional CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers, these large payout is again the reason of bankruptcies of the bank


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IMPACT:-

Loss of 95% market value

The Standard & Poor’s 500 index declined 27.33 points or 2.2% in NEW YORK

Dow Jones industrial average sank 300.20 to 11121.79


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CONCLUSION

Financial crises are terrifying when underlying economic fundamentals are out of line


PRESENTATION BY:- 1) ANAND AGRAWAL 2) RAHUL GARG 3) RUCHI KHARB 4) NIDHI PANDEY 5) ANAMIKA HANDIQUE 6) SOURABH KHURANA 7) SUNIL PATEL

final ppt cds anamika handique iipm fn5

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