Credit default swaps and their market mechanisms

Credit Swap, also known in some circles as a Credit Default Swap is one of the most basic credit derivatives. Here in this transaction, one party called the Protection Buyer in return for a payment by the other party called the Protection Seller makes a periodic payment, which is dependent on the happening of some agreed-upon event that is related to an original credit.

To quote a simple example that may have a buyer, who has a public security of Corporation A, that pays a monthly fee to the seller. On the other hand the seller has a commitment to make a prearranged payment to the buyer. However, this commitment comes up only in the event of Corporation A, which is being declared as insolvent. Thus the flexibility is apparent when both the parties recognize that the terms can be negotiated between them and can also associate to further aspects that might be other than the fees and payment such as the "event" that starts the payment that may be the decrease of a credit rate, and a restructuring of Corporation A's debt, along with the level of specificity or complexity that has been agreed upon.

Understanding the Applications of Credit Default Swap

In order to know the applicability of the credit default swap, one should firstly understand as to what is meant by credit swap. It is a swap in which one of the counter parties gets payment at pre-set intermission in order to consider for guarantee to make a specific payment when a negative credit event take place. One possible type of credit event for a credit default swap is a downgrade in the credit status of some preset entity. Example:

Bank 1 - First Chilliwack Bank

Bank 2 - Banque de Bas.

An extensive loan has been made by Chilliwack in its corporate credit portfolio to a property developer known as Churchill Developments. But it seemed that for some kind of insurance against a downgrade of Churchill by the major ratings agency, the possibility of this main project taken on by Churchill has been running into unanticipated delays.

Therefore, Chilliwack approached to Banque de Bas along with the concept of a credit default swap or say credit swap, which means that in exchange they pay Banque de Bas a payment every six months for the next five years for which in return de Bas has agreed to make payments to Chilliwack of a pre-set amount.

Thus, now De Bas has exposure to Churchill, which is having a position they could not have been able take directly since they are not part of Churchill's lending association. Furthermore, Chilliwack to some degree has protection against a Churchill credit downgrade. However, this reduction means in their overall credit profile that they do not require holding as much capital in reserve, and making Chilliwack free in order to take other business opportunities as they present themselves.

Instruments in Credit Swap

Corporate Bonds

At a premium, the corporate bonds trade to the risk-free yield curve in the same currency where the United Sates Corporate Bonds trade at a premium to the U.S. Treasury curve, which is also known as a credit spread. This credit spread is unstable in the manner of in and of itself and may be associated with the level of interest rates.

For instance, in a low interest rate and in a declining environment that is combined with strong domestic growth, one may expect corporate bond spreads to be smaller than their historical average.

The corporate that has issued the bond may find it much easy to service the cash flows of the corporate bond. The investors on the other hand may be greedy for any sort of premium they can add to the risk-free rate. Furthermore, the year 1998 was dynamic for corporate bond spreads, which had the backup in interest rates and in the aftermath of the Russian devaluation-inspired liquidity crisis that was concentrated mainly in corporate yields. However, the instability of these spreads was tremendous when compared to their historical movement, where the credit swaps was an excellent way to play the spread volatility.

In addition, credit swaps especially that is much based on a spread index, are clean structures that have no disordered difficulty of locating individual corporate bond supply, etc.

Exchange of Fixed Flows

Furthermore, a credit swap can also be the exchange of fixed flows against paying floating rate flows, where fixed flows is determined by the production on a corporate bond at inception and the floating rate flows is tied to the risk-free Treasury rate for the corresponding maturity.

Moreover, the credit swaps are flexible in their design in a natural manner. Thus, if one can imagine a cash flow exchange, then the structuring of the swap can be imagined too.

Strategy for Management of Funds through Credit Swap for Financial Institutions

Here if the fund manager specialized in corporate bonds and has a view on the direction of credit spreads on which he act without taking a specific position in an individual corporate bond or a corporate bond index. Thus, one way for the fund manager to take advantage of this view is to go into a credit swap.

At this stage the fund manager believes that credit spreads may be tighten along with the interest rates that continue to go in decline. He may then enter into a credit swap in which he pays the corporate yield at six-month intervals against receiving a fixed yield equal to the inception Treasury yield along with the corporate credit spread. This is almost following the same principles, as done by the two banks: Chilliwack and Banque de Bas.

Thus, the fund manager at the six-month reset for the tenor of the swap agrees to pay a flow of cash determined to be balance to the existing annual yield either on some benchmark corporate bond or corporate bond index in order to receive a fixed cash flow.

Therefore, this off-balance sheet transaction and the swap will have zero value at inception. Therefore, if corporate yields continue to fall that is through a combination of a lower risk-free rate and a lower corporate credit spread than the one he locked in with the swap, he will make money, but on the other hand if corporate yields rise, he will lose the money.

Advantages in Credit Swaps

Risk Neutral Pricing Strategy

How risk neutral pricing theory can be applied to price a credit default swap or credit swap cab be known when the price is obtained by clearly constructing a hedge from the underlying cash market instruments.

Here the credit default swap is the most straightforward type of a credit derivative, which has an agreement between two counter parties that permits one counter party to be "long" a third-party credit risk, and the other counter party to be "short" the credit risk. In other words, one counter party is selling insurance and the other counter party is buying insurance against the default of the third party.

To further insight this kind, lets suppose that two counter parties, known as a market maker and an investor, both move into a two-year credit swap by specifying what is called the reference asset. This is a particular credit risky bond that is issued by a third-party corporation or sovereign.

In simple words, let us suppose that the bond has exactly two years' remaining maturity and is currently trading at par value where the market maker agrees to make regular fixed payments, which has the same frequency as the reference bond for two years to the investor. Then in exchange of this the market maker has all the right. However, at any time if the third party defaults within those two years, the market maker has to make his regular fixed payment to the investor and places the bond to the investor in exchange for the bond's par value along with the interest.

Implications of the Strategy

The credit swap or default swap is thus a contingent put, where the third party must default before the put is activated. Here in this example there is small difference in terms of risk between the credit swap and the reference bond since the swap and the bond have the same maturity, and the market maker successfully is short the bond and the investor is long the bond. However, in the real world, it usually happens that the bond tenor is longer than the swap tenor meaning that the swap counter parties have exposure to credit risk, but do not have exposure to the full market risk of the bond.

Thus, this above example clarifies as to how the instrument is priced. However, pricing the credit swap involves determining the fixed payments from the market maker to the investor, which in this case is ample to extract the price from the bond market and so one does not require modeling default or any other complicated credit risk process.

Model and Application of the Risk Neutral Pricing Theory

In order to apply risk neutral pricing theory one needs to construct a hedge for the credit swap where it is sufficient to construct a static hedge, meaning that the cash instruments are purchased once only, for the life of the credit swap and they will not have to be sold until the termination of the credit swap. Thus, the hedge is different for the market maker and investor. But again if the market maker were to hedge the credit swap, then it would need to go long the bond.

Moreover, the market maker borrows money in the funding markets at Libor and uses those funds in order to purchase the corporate bond that pays Libor + A basis points. The hedge, however, is paying the market maker a net cash flow of A basis points but again if the reference asset does not default, then at the termination of the swap the market maker will let everything go the hedge at no net cost and if the reference asset defaults, then the market maker right away unwinds the hedge. Thus, delivering the bond to the investor in exchange for the par amount, and pay back its borrowed funding with the principal.

This completely hedges the market maker's risk in the credit swaps. However, if the same reasoning is applied on the investor where he hedge the credit swap, then short the bond is required. Furthermore, the investor borrows the bond in the repo-markets, where in order for him to borrow the bond, he lends the face value of the bond to the repo-market, which will be a sub-Libor rate.

Let's suppose the investor lends the par value of the bond at Libor Y basis points in exchange for borrowing the bond where the bond lender then keeps the bond's coupon payments. Thus, for two reasons the value Y may be relatively large. Firstly, the investor is making a collateralized loan in which the bond is collateral against the loan, so the borrower expects a low borrowing rate. Secondly, the market for shorting the credit risky bond is inefficient and the value of Y may be between from 20 to 150 basis points.

The bond is then sold by the investor in the debt markets and pays Libor + X basis points to the bond buyer. This hedge costs the investor a net cash flow of X + Y basis points and completely hedges the investor's risk in the credit swap.

One can observe that the hedges are not symmetric as the market maker is receiving X basis points from his hedge while on the other hand the investor is paying X + Y basis points from his hedge. Thus, the hedges reveal the price of the credit swap up to a range and leave the market with a spread of approximately Y basis points that cannot be arbitraged away. However, where exactly the price of the credit swap falls in the range of X to X + Y depends on the counter parties and their motivations.

Furthermore, the counter parties to credit swaps enter into customized, off-balance sheet transaction, which has certain intangible advantages over the cash markets such that the market makers or commercial bank lenders look for credit protection on a certain name and may be willing to pay as much as X + Y or even more.

While on the other hand an investor who seeks for some extra premium may be willing to accept as little as X or even less and the market makers along with sub-Libor funding rates, as well as the investors with above-Libor fund ingrates, will find the credit default swap even more promising and encouraging.

Disadvantages in Credit Swaps

Complexities in Strategic Applications

Generally, pricing credit swaps is not that simple. As mentioned in the above discussion that the bond tenor may well be longer than the swap tenor, but at the same time in often cases the bond is not trading at par, or that coupon payments are fixed rather than floating. Furthermore, the price also depends on the specific terms of the swap agreement as well as the reference security.

Moreover, regardless of the simplicity, it also demonstrates many things such as, risk neutral pricing theory both work and at the same time does not work in the credit markets. However, it gives a good bound for the price of the credit swap, but does not give a single price since the assumptions of risk neutral pricing do not apply, which include market completeness, liquidity and lack of transaction costs.

Credit Risk in Management of Credit Swap

Credit risk can be understood as the risk resulting from ambiguity in any counter party's ability or readiness to meet its contractual obligations, which can become visible in default risk, which is the risk of loss when the counter party does not succeed to meet its obligations when due along with the spread risk, which again is the risk where a change in an obligor's credit quality affects the value of a debt security and hence spread credit.