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Cr derivative
- make pmt if a specific cpy defaults. Uses include
- reduce risk exposure to a specific counterparty
- diversify risk (buy when exposed, sell otherwise)
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CDS = credit default swap
- protects agains cr event of reference entity
- buyer makes periodic pmts = CDS spread
- if cr event occurs, buyer can sell bd for notional principal and not futher CDS spread is required except accrual
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CDS settlement types
- physical settlement: sell bds at face value
- cash settlement: seller pays diff btwn face value and value of cheapest avail bond
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CDS swap & bond yield
- CDS spread = yield on corp bd - rf
- CDS-bond basis: expected to be zero
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Valuation of CDS
- PV(exp pmt) + PV(accrual pmt) = PV(exp payoff)
- PV(accrual) = default prob * s/2 * disc
- PV(exp pmt) = survival prob * s * disc
- PV(exp payoff) = default prob * (1 - R) * disc
- can assume more frequent pmt or default
- when issued, value = 0; chg as spread chg
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ABS = asset backed securities
- security made up of a pf of financial assets
- firm transfers to SPV = special purpose vehicle
- SPV issues securities backed by CF of assets
- high rating of first tranche not justified if assets are highly corr
- CDO-squared: repackaging of mezzanine tranches
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CDO = collateralized debt obligation
- type of ABS where assets are corp or country bds
- long bond = short CDS
- synthetic CDO: CDO w short CDS
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2008 financial crisis
- rating agencies provided ratings to financial instruments (original mandate = single-name corporation) -> correlation
- amt of non-conforming mortgages incr while quality of subprime borrowers deteriorated
- CMO biased against investors: (1) higher prob of default due to quality of borrowers (2) lower R due to pressure to sell (3) high correlation (4) high impact of errors in estimate
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