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Credit Default Swaps (CDS): Your Insurance against Unwanted Defaults [Part-5]

Dear reader, congrats on making it till here. This is the final part of the CDS series. If you haven’t gone through the earlier ones, kindly go through them using the following links:

  • CDS: Your Insurance against Defaults (Part 1)
  • Basics of CDS Valuation (Part 2)
  • Structural Valuation of CDS (Part 3)
  • Black Swans & CDS: A Complicated Relationship (Part 4)

CDS Restructuring:

At the end of Part 4, we started exploring a violation of principle. Swaps are generally zero-cost instruments, yet the Voda-CDS has a price. So, how does this violation work? The answer lies in the concept of CDS Restructuring. Let’s understand this concept through an example:

CDS premium = 5.00%   
YearPremium Outgoing (-ve)PV (outflows)Default Incoming (+ve)PV (inflows)
1-5.000-4.8395.0004.839
2-4.750-4.4447.0216.568
3-4.399-3.97517.63115.930
  
Net -13.257 27.337
  FV of CDS 14.079
Table 1: Expected Cashflows from Voda-CDS when premium is 5%

As observed in Table 1, when the CDS premium (as per the T&Cs of the contract) is 5.00%, the value of the CDS is 14.079. This is the upfront fee the CDS buyer will be paying to the seller. This upfront fee arises when there has been some rating transitions in between the origination of the contract and the time when the CDS is to be sold to the interested entity/potential buyer. The buyer compensates the seller for any additional credit risk he has borne apart from that mentioned in the contract.

CDS premium = 10.31%   
YearPremium Outgoing (-ve)PV (outflows)Default Incoming (+ve)PV (inflows)
1-10.310-9.9795.0004.839
2-9.795-9.1637.0216.568
3-9.071-8.19517.63115.930
  
Net -27.337 27.337
  FV of CDS 0.000
Table 2: Expected Cashflows from the Voda-CDS when premium is 10.31%

Now, if you look at Table 2, you’ll find something interesting. If the existing CDS contract is restructured such that the annual CDS premium becomes 10.31%, the upfront fee becomes 0. This is known as No-arbitrage CDS value. Now, if a CDS buyer wants to pay the seller in form of staggered payments instead of a hefty upfront fee, he might want to restructure the CDS before the deal is finalized.

Effective Leverage in a CDS:

It is similar to typical derivatives like Futures & Options where Hedge ratio/Effective Leverage is calculated based on the no. of contracts needed to hedge total exposure. CDS Hedge ratio is calculated using its No-arbitrage value. For our example, we calculate HR as follows:

  • Someone might get confused whether the CDS premium or the CDS price should be used to calculate effective leverage. As we can see in Table 1, both CDS premium (5%) and CDS price (14.079) pertain to hedging $100 worth of credit exposure. If he/she uses 5, he’ll get a HR of 20 while it will come out to be 7.1 if the CDS price is used. Both are wrong.
  • We should always use the No-arbitrage CDS premium value i.e. 10.31. It means that without any upfront fee payment, a CDS buyer would be paying $10.31 to hedge $100 of credit exposure each year. Thus, HR = 100/10.31 = 9.7.

Concluding Remarks:

On 17th Feb, 2021, Reserve Bank of India (RBI) gave the final nod to retail participation in CDS transactions. That means if you have any exposure to bonds of a company which might face financial distress in short term (like Future Retail after Amazon’s intervention in the Future-Reliance deal), you can now buy CDS to hedge your credit risk. I hope you’ll find this CDS series (5 parts) useful and interesting. I’ll be starting a similar series on Interest Rate Swaps (IRS) soon. Hope to see you there as well!

Sayantan Ghosh

MBA (Finance), FMVA®