Dear reader, congrats on reaching to Part-2 of this series. If you’re here, I’m assuming that you must’ve already gone through the Basics of CDS in Part-1 of this series. If not, kindly click here and read Part-1 before proceeding any further for a better understanding.
Credit Spreads & CDS Premiums:
Before doing the valuation of a CDS, you need to understand what is meant by Credit Spread. In the world of Finance, we assume that the Government of any country will not default (though there have been contrasting instances like Greece) and doesn’t carry risks unlike common firms or business enterprises. This is the primary reason why we often take Govt. security yields as Risk-free rates in valuation.
All firms have some degree of exposure to Credit risk. The stronger its financials, the lower credit risk a firm exhibits and thus, it is considered to have a low risk premium over the Govt. Similarly, firms with weaker financials possess higher risk of triggering a Credit event and must have higher risk premiums. These risk premiums are quantified in form of Spreads which are inversely related to the strength of a firm. Spread volatilities are highly dependent on its values i.e. Higher yields will exhibit much more rise in spreads during periods of economic distress compared to lower yields (Fig 1). CDS premiums are an indirect function of the Credit spreads and are negotiated during the first-time creation of a CDS contract based on prevalent spreads at that time.
Rating Transition Matrix:
Any insurance or risk-transfer tool has a common element at its core – the probability that the risky event (credit event in our case) actually happens. This is best illustrated using the concept of a Rating Transition Matrix (RTM). A RTM indicates the probability a firm retains the same credit rating from previous year or gets upgraded/downgraded. RTM has been standardized by CRAs like S&P & Moody’s and global organizations like OECD.
Let’s understand how to interpret a RTM. We start with a firm that currently has a BBB rating. The ratings in the 1st column refer to the current rating of a firm while the ratings in the 1st row refer to the rating in the next period/FY. One interprets a RTM as follows:
- The probability that no significant event happens and the firm retains the same BBB rating in the next FY as well is 66%,
- There is a 9% probability that the firm gets upgraded from BBB to AAA,
- There is a 20% probability that the firm gets downgraded to CCC,
- Finally, in worst-case scenario, the probability of a BBB rated firm defaulting in the next FY is 5%.
As observed in Table 1, chances of lower rated firms triggering a Credit event are much higher than those with a higher rating. Accordingly, CDS premiums of lower rated firms are also considerably higher while creating a CDS contract.
Q/Q Reset rate (Discount rate):
All types of Swaps (IRS, CDS, TRS etc.) have an underlying discount rate (mostly reset on a quarterly basis). This rate is used to discount the expected cash flows from the swaps at the time of creating the contract. In USA, this rate is usually the 3-m T-bill yield/SOFR while it is 3-m LIBOR for EU. In India, the closest proxy of a 3-m risk-free rate is the 91-DTB (91 Day Treasury Bill yield). The yields are generally annualized over the life of the CDS contract.
Now that we’ve covered all the basics, we’ll look at a comprehensive illustration of the Structural CDS Valuation process in Part 3 of the CDS series. I’ll be looking forward to seeing you there!