A Credit Default Swap (CDS) - Coursework Example

?Credit Default Swap Spreads Number Department Grade 6th March, Introduction A Credit Default Swap (CDS) is a monetary swap agreement between parties designed to shift the credit exposure of unchanging income products (Choudhry, 2006). The agreement facilitates the lender or creditor to transfer credit from a third party to an insurer who agrees to insure the risk of default payment of credit. The creditor must make periodical payments (which are taken to be insurance premium) to the insurer, and the insurer will pay the creditor in case the there is default. The fixed periodical payments made by the creditor or the buyer of a Credit Default Swap are known as the CDS fee or commonly referred to as CDS spreads. The buyer of the Credit Default Swap can only receive the exact value of the credit or loan and can not be compensated beyond that value. The seller of the Credit Default Swap (or the insurer) takes possession of the defaulted credit or loan, obtains right of ownership and can therefore sue to recover the credit. The value of the spreads to be paid should be determined so that the buyer of the Credit Default Swap can pay the correct value for the Credit Default Swap. Consider an example where a buyer of Credit Default Swap enters a five year contract to pay CDS spreads on Ford Motors credit with a principal of $10 million at 300 basis points. This means that the buyer pays $300,000 per year and obtains the right to sell bonds worth $10 million issued by Ford of that value in the event of a default by Ford. This thesis is divided into three parts which cover the topic in Credit Default Swap spreads in details. Part 1: Determining CDS Price Credit Rating There are different methods used to establish the price of a Credit Default Swap for a company listed in the stocks market. One of the methods is using the credit rating. Credit rating is an assessment of the credit worthiness of a corporation listed in the stock exchange. Credit rating approximates the ability of a corporation to meet its credit based on earlier dealings. Credit rating for corporate bonds issues are produced by rating agencies such as Moody’s, Standard and Poor’s (S&P) and Fitch Ratings. Bonds can be rated ranging from AAA to D. Bonds with AAA rating are considered to have almost no chance of default and its CDS spreads are expected to be lower compared to D rating which have a very high risk of default and its CDS spreads expected to be far more expensive. Probability Model There are other quantitative methods that can be employed to determine CDS spread to be paid. The probability model is one of the quantitative methods. This method recommends that credit default swaps should trade at a significantly lower spread than company bonds. The price of a Credit Default Swap is determined using a representation that considers four factors which are; issue premium, recovery rate (which is the percentage repaid in the event of default), credit curve and LIBOR curve. The price of a Credit Default Swap would be determined by adding the discounted premium payments. To explain the probability method better, imagine a case of one year Credit Default Swap which will be effective on lets say date t with a quarterly spread payment taking place on dates t1, t2, t3 and t4. If the nominal for the Credit Default Swap is N and the issue premium is C, then the value of the periodical spreads is given by the formula NC/4. If we imagine the default can only happen on one of the payment dates, then the swap agreement can end when; it lacks a default within agreed time and so the spread payments are made and the agreement endures until maturity date or, a default takes place either on first, second, third or fourth compensation date. The price of the Credit Default Swap is now determined by assigning probabilities to the five probable results. Labor Rate Labor rate can also be employed to benchmark the price for Credit Default Swap securities of a listed company. Labor is the interest fee which financial organizations charge each other for short term loans lent. This is an acronym for London Banks Offered Rate which is collected by the British Bankers Association and published on a daily basis. Since Labor is used to set interbank interest rates, it also affects a bank’s interest rate, (which includes loans given to its customers and mortgages). Where the Labor rate is too high, the risk of credit default increases. This is because the interest rates of individual banks will rise as a result of high interbank loans interest rates. The high interest rates will to default by the customers of the banks. In such a situation, if the banks may seek to enter into a Credit Default Swap, the price is likely to be high since the probability of default is high. This case can best be explained by the 2008 financial crisis in the United States of America where banks gave out mortgages to its customers with no expectation of a rise of Labor which affected the price of CDS. Part 2: Liquidity Spillover and CDS Spreads Credit spreads can be affected by the prices of securities such as stocks and bonds traded in different markets. Credit Default Swaps are not only affected, but their trade can also have a market-wide impact as demonstrated by 2008 financial crisis in the United States of America. Mortgage-backed security swaps were insured and there was a case of default country-wide due to high interest rates. The stocks of insurance companies such as AIG fell drastically since it was a major seller of credit default swaps. The company had to pay off the defaults as it was approaching its bankruptcy state. Its company shares were operating at loses since its profits were drastically declining. The 2008 financial crisis which stated in the United States of America was characterized by drastic changes in bond, equity and options markets prices. Adjustments in credit spreads were a significant contributing factor to securities price volatility. In light of these past events, the impact of credit spreads on bond and stock prices is significant and should be analyzed by financial economists, investors and regulators so as to understand the markets that are affected by credit risk. It is important to not the fact that credit derivatives such as Credit Default Swaps are over-the-counter agreements therefore the parties to the contract can freely negotiate the terms and conditions. This means the role of liquidity in pricing of these securities may be different from that of bond, equity and stock. Credit spreads of bonds issued and the prices of credit default swaps written on the bonds may be used to measure the credit risk associated with a corporation. Credit risk can also be quantified using credit spreads which are not written on the bonds. For example, information concerning credit risk can be obtained from equity prices. Credit Default Spreads contracts are frequently traded together with other securities and therefore a likelihood of liquidity or illiquidity of other markets could spill over to the Credit Default Spreads market. This shows that other market liquidity may control the Credit Default Spreads. The tables below show the effects of illiquidity spillover from bond, stock and option markets to Credit Default Spreads. Liquidity Spillover from the Stock Market The table below shows the analysis of liquidity spillover resulting from stock markets and its effects to the Credit Default Swap market. It illustrates that Credit Default Swap spreads are higher when reference entity’s stock is not liquid. It can be verified that a one standard deviation (0.03) increase in stock illiquidity is associated with an increase in CDS spreads by twenty nine basis point. Full Sample Inactive Subsample Active Subsample Coefficient T-stat Coefficient T-stat Coefficient T-stat CDS Liquidity 0.07 1.33 -0.66 -2.79 0.15 3.57 Stock Illiquidity 961.93 2.05 859.13 1.86 2630.35 2.36 Stock PIN -74.63 -2.27 -81.29 -2.48 -87.95 -1.77 Adj. R2 0.593 0.595 0.608 Liquidity Spillover from the Corporate Bond Market The theory financial market proposes that Credit Default Swap spreads and corporate bond spreads for the same corporation are bound by no-arbitrage conditions. By paying no attention to differences in liquidity and presuming the maturity of the firm’s credit equals that of the Credit Default Swap, an investor who obtains a corporate bond and buys protection for the same reference entity in the Credit Default Swap market should be evaded against the default of this particular corporation (Choudhry, 2006). The table below shows confirmation of liquidity spillover caused by the bond market and in result affecting the Credit Default Swap market. It is observable that when the reference issues are older, the Credit Default Swap spreads are lower. A one standard deviation move in bond age is associated with a change of 6.0 basis points in Credit Default Swap spreads. Full Sample Inactive Subsample Active Subsample Coefficient T-stat Coefficient T-stat Coefficient T-stat CDS Liquidity 0.05 1.54 -0.75 -4.17 0.09 3.15 Bond Age -2.68 -2.24 -3.01 -2.47 -0.75 -0.40 Bond Maturity 0.67 1.52 0.54 1.47 1.02 1.62 Bond Coupon 0.91 0.47 0.73 0.39 1.91 0.72 Bond Amount 5.56 1.69 4.35 1.31 15.27 2.94 Adj. R2 0.582 0.577 0.627 Liquidity Spillover from the Stock Option Market The table below shows confirmation of liquidity spillover caused by option market that ends up affecting the Credit Default swap markets. Option trading volume is negatively associated with Credit Default swap spreads. A one standard deviation increase in option volume is associated with a decrease of 14.0 basis points in Credit Default swap spreads. Option open interest is significantly positively related to Credit Default swap spreads with a liquidity premium of 28.7. One must be aware of potential multiple correlation between volume and open interest which is 0.796. Full Sample Inactive Subsample Active Subsample Coefficient T-stat Coefficient T-stat Coefficient T-stat CDS Liquidity 0.06 1.89 -0.68 -3.94 0.10 3.64 Option B/A 11.83 0.40 8.98 0.31 11.59 0.18 Option Volume -1.30 -2.99 -1.51 -2.24 -0.93 -2.90 Option O/I 9.21 3.46 9.80 3.21 8.18 2.98 Adj. R2 0.588 0.583 0.630 Credit Default Swap liquidity may also have a significant effect on CBS spreads for the frequently traded and infrequently traded subsample. A one-standard deviation move changes CDS spreads by 6 basis points. Part 3: CDS Spreads and Sovereign Risks in Developed and Emerging Markets Sovereign risks are those risks that result from a central bank’s regulations on foreign exchange or a foreign central bank’s alterations of its monetary policy or other foreign exchange regulations which consequently impose a risk to traders, corporations and economies at large. Sovereign risks are not necessarily caused by a country’s central bank; political risks may also lead to sovereign risks. Recently just after the 2008 financial crisis, there has been an increase in monitoring sovereign risks. Monitoring of sovereign risks has proved to be of great significance in avoiding risks that may cause an effect in other economies. Another example of a sovereign risk is the debt crisis in Greece which has affected the entire Euro area. The debt crisis has spilled over to banking systems resulting in rise of credit and market risks. The steady decline in sovereign rating has spread beyond Greece, Ireland, Portugal and the entire Euro region, and now it’s starting to be a major factor to be considered in the other Countries in Europe. The debt crisis has affected security markets and resulted in the rise of liquidity risks, partly caused by rising macro-economic and sovereign risks. Elevated volatility and increasing dividends on government bonds given by countries on the Euro zone are also threatening a loss of investor confidence, weakening the investor base, and further driving up interest rates. As a result, financing of public debt has become more complex, which has resulted in default of loans taken by individuals. Credit Default Swap may be difficult to acquire since there is a high likelihood of default in the macro economic point of view. High sovereign risk premiums have disrupted bank funding markets and raised the credit risks due to the spillover of sovereign strains to the banking system. Emerging markets risks and Credit Default Swap spreads may increase due to the swift domestic credit growth, balance sheet leveraging and rising asset prices. This might result to depreciating bank asset excellence in rising markets as the credit cycle is established and still the markets remain vulnerable to external shocks. High Credit Default Swap spreads can originate from a predictable deceleration in overall economic activities. This results to low corporate profitability and high default risk. Nevertheless, higher Credit Default Swap spreads can also take place in an environment noticeable by little financial market liquidity. During such periods financiers usually demand for a high premium for investment in risky credit related instruments. Credit Default Swap spreads are of great significance to emerging economies since they act as a form of hedge funds. The risk of credit default is catered for and so lenders have security for there finances. Conclusion A Credit Default Swaps are increasingly used to manage risks associated with credit default in these recent days. However, Credit Default Swap spreads are affected by various factors which have been discussed in part 1 of this thesis. Some of the factors that affect the price of Credit Default Swap can be subjective to the credit rating of the debtor. Where the rating is low, then the price to be paid is anticipated to be high since there are high chances of default. Probability model can be used to establish the price to be paid for A Credit Default Swap by considering the possibility of default to take place. Labor rate is another factor that influences Credit Default Swap since they affect interest rates of loans. Where the Labor rate is too high, the risk of credit default increases hence higher chances of default by mortgages and loan borrowers. Credit Default Swap spreads are also affected by bond, stock and option market spillovers. This has been discussed in part 2 of this thesis. Stock market spillovers greatly affect Credit Default Swap spreads as illustrated in the tables above. It is evident that also bond and option market spillovers influence Credit Default Swap spreads. Political and economical policies and regulations of other foreign countries may also influence a given country’s Credit Default Swaps spreads. This has been discussed in part 3 of this thesis. It has considered the impact of the Greece debt crisis on other countries Credit Default Swap spreads. Sovereign risks have become a major concern on Credit Default Swap since they greatly influence the spreads. Reference Choudhry, M., 2006. The Credit Default Swap Basis. New York: John Wiley and Sons. Read More