Update : Feb. 29, 2012
Credit risk is most broadly defined as the risk of a debtor not being able to meet its obligations.
Debt guarantees or default insurances have been hedging tools for corporate credit risk. A Credit Default Swap (CDS) is globally standardized means of transferring credit risk between two parties.
CDSs are traded over-the-counter (OTC) mainly between financial institutions. Under a CDS trade, the party which wants to short credit risk (referred hereafter as "Protection Buyer") makes fixed periodic payments (referred hereafter as "Fixed Coupon"), while the party who takes the risk (referred hereafter as "Protection Seller" ) receives the coupon. In case of certain corporate events including bankruptcy, failure to pay, and debt restructuring (referred hereafter "Credit Event") recognized by third parties, the affected CDS contract is settled between the two parties. If a Credit Event does not occur during the term, the CDS contract terminates without any other cash flow other than fixed coupon payments made from Protection Buyer to the Protection Seller. After Credit Event has occurred, the settlement price is generally determined in an auction organized by International Swaps and Derivatives Association, Inc. (ISDA). The auction results administrated by Markit and Creditex, and is published on the following website:
Credit index trading is similar to bond trading in that the coupon and maturity are fixed before the roll. For credit indices, payments from the Protection Buyer to Protection Seller are made on a quarterly basis (referred hereafter as "Fixed Coupon"). The rate of the Fixed Coupon is determined for each index before the roll and remains same until the maturity (For example, the coupon for the Markit iTraxx Japan Series 11index is 500bps).
Upfront payments are made at initiation between the Protection Buyer and Seller, and close of the trade to reflect the change in spreads. The price (referred hereafter as "Index Price") is par minus the present value of the spread differences. (Please see the trading example below for more details.) Market participants use calculation tools provided by external vendors to calculate Index Price. Markit also offers a free calculation tool for CDS indices trading which can be accessed from the link below.
Here is an example of how CDS Indices are actually traded in the market.
Over the period of the contract in which Protection Buyer A buys the protection from Protection Seller B, there are three kinds of cash flows i.e. upfront payment, coupon payments and settlement payment. The sequence of dates for the trade is briefly summarized as follows:
1. Index Roll Date: On 20Sep08 the credit index launches with a price of 100%, 5 year term and a fixed coupon of 60bps.
2.Trade Start Date: On 30Nov08 Protection Buyer A buys JPY 100 Million notional protection on the index when the spread has moved to 90bps.
3. Trade Settlement Date: 03Dec08 (=Trade Date + 3 business days)
4. Fixed Coupon Movement: On 20Dec08 Protection Buyer A pays Protection Seller B the fixed coupon.
5. Trade Termination Date: On 13Mar09 Protection Buyer A closes the trade when the spread goes up to 120 bps.
6. Trade Settlement Date: 16Mar09 (=Trade Termination Date + 3 business days)
The Protection Buyer A pays the Protection Seller B an Upfront (par minus the present value of the spread differences) and Accrued Interest Differences to trade credit indices. In this example where the index spread is 90bps on the trade date, the price is 98.67 % (calculated by the price calculation tool offered by Markit). The payments are calculated as follows and are made three business days after the traded date.
Fixed Coupon = Notional * Fixed Coupon = JPY 100 M * 0.006 = JPY 600,000
The Protection Buyer A pays the Protection Seller B the fixed coupon. Please note that the fixed coupons are quarterly made on 20Mar, 20Jun, 20Sep and 20Dec. If the payment date falls on a holiday or a weekend, the payment is made on the following business day
Assume that Protection Buyer A unwinds the trade by selling protection. On the termination date when the spread is 120bps and the equivalent price is 97.44%, the Protection Buyer A pays the accrued interest accumulated up to the trade termination date and receives the Index Price difference (the Index Price at the launch date (100%) minus the one at the traded date(97.44%)).
The Protection Buyer receives the difference in the payments above, JPY 2,386,667 (=JPY 2,560,000-JPY 173,333).
|Date||Event||[Protection Buyer A]Cash Inflow(+)||[Protection Buyer A]Cash outflow(-)||[Protection Buyer A]Net Cash flow|
|20Sep08||Index Roll Date:
Fixed coupon: 60bps
|30Nov08||Protection Buyer A buys JPY 100 M notional protection on the index, when the spread has moved to 90bps and corresponding price is 98.67%.||-||-||-|
|03Dec08||The settlement date for the trade entered on 30Nov09.||Accrued Interest
|20Dec08||Coupon Payment||-||Coupon Payment
|13Mar09||Protection Buyer A unwinds the trade when the spread is 120bps and the equivalent price is 97.44%.||-||-||-|
|16Mar09||The settlement date for the unwind trade done of 13Mar09.||Index Price Difference
Total Cash Flow
|JPY 2,678,333||JPY 2,103,333||JPY 575,000|
When a Credit Event occurs in any of the constituents of a credit index, the Protection Seller pays the Protection Buyer for the loss caused due to the affected entity. After the Credit Event, a new version of the index will be issued with the defaulted entity removed. The notional amount used for calculations would be reduced by an amount corresponding to the weight of the entity in the index (assuming 50 names in the index, the new version will contain 49 entities and will have a revised notional). International Swaps and Derivatives Association, Inc. (ISDA) administers the determination of Credit Event and settlement methods.
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