UNIVERSITY OF PIRAEUS DEPARTMENT OF BANKING AND FINANCIAL MANAGEMENT The uses and the valuation methods of Credit Default Swaps Theodore Chantzis MXAN1228 February 2014 Supervisor: M. Anthropelos Examination Committee: A. Antzoulatos, N. Egglezos 1 Contents 1. Introduction ..................................................................................................................2 2. Credit Derivatives .........................................................................................................3 3. Credit Default Swaps ....................................................................................................7 3.1. Definition and Structure .........................................................................................7 3.2. Credit Default Swap Market Today ...................................................................... 10 3.3. Credit Default Swap Documentation .................................................................... 13 Definition of Credit Events and CDS Triggering ............................................................. 17 Credit Default Events since 1997..................................................................................... 22 Macroeconomic Drivers of Sovereign CDS Spread ......................................................... 23 European Debt Crisis ...................................................................................................... 27 Greece Debt Restructuring in 2012 .................................................................................. 31 4. Uses ............................................................................................................................ 34 Speculation ................................................................................................................. 34 Hedging ...................................................................................................................... 38 Arbitrage ..................................................................................................................... 40 5. Credit Default Swaps Pricing & Valuation................................................................... 45 6. Regression Methodology ............................................................................................. 47 2 1. Introduction This thesis studies Credit Derivatives and especially the nature of Credit Default Swaps (CDS) and their main characteristics. CDS attracted the attention of policy makers and market investors after the global financial crisis of 2007. In addition, during the European debt crisis, CDS became very popular, thus they offer trading for a wide range of instruments (fixed income and equity) with exposure to credit risk. The reason why it is so important that more is known about the accuracy of sovereign CDS spreads is that sovereign defaults can severely damage the global financial stability. The sovereign credit risk that is attached to a nation has a bigger impact on the financial system than macro-economic risks, market liquidity risks, and emerging market risks (IMF 2011)1. Furthermore, in the thesis, it is described how CDS markets work, the basic structure of CDS, the documentation, the strategies which are based on CDS contracts, like hedging, arbitrage and asset swap. We also review the literature which deals with CDS pricing, the basic determinants of CDS and factors affect the strategies and examine the relationship between CDS spread and key macroeconomic factors, especially in Portugal, Italy, Ireland, Greece and Spain (PIIGS). 1 International Monetary Fund. (2011). Global financial stability report October 2011, p2 3 2. Credit Derivatives Derivatives are either simple or complex financial instruments specifically designed to effectively hedge or transfer several risks between two or more counterparties. Because of this specific nature, derivatives are very popular in financial markets, especially during periods characterized by high uncertainty and volatility. Definition I “Credit derivatives are financial instruments that are designed to transfer the credit exposure of an underlying asset or assets between two parties.” In general a credit derivative refers to one of any of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the debt- holder. Fabozzi et al. (2004), D. Satyajit (2005) & M. Simkovic (2009) Formally, credit derivatives are bilateral financial contracts that isolate specific aspects of credit risk, concern an underlying instrument (bond, loan, stock etc). These instruments are used in order to transfer that risk between two parties. Credit derivatives are fundamentally changing the way banks price, manage, distribute, and account for credit risk, but also how institutional investors think in order to hedge credit risk. For example in the case of bank loans which are not traditionally appeale to be accounted as an asset class, hedging is needed via an other non-bank institutional investor for two main reasons: (i) the administrative burden of assigning and servicing loans; and (ii) because of the absence of a repo market to finance 4 investments in bank loans, the return on capital offered by bank loans has been unattractive to institutions that do not enjoy access to unsecured financing. Credit derivatives, despite when they are included in structured notes or other products, are off-balance- sheet instruments. In these cases, offer considerable flexibility to leverage and achieve arbitrage gains. In fact, the user can define the required degree of leverage, if any, in a credit investment. The category of credit derivatives include credit default swaps, asset swaps, total return swaps, credit-linked notes, credit spread options, and credit spread forwards. Credit derivatives are fundamentally divided into two categories: (a) funded credit derivatives and (b) unfunded credit derivatives. Figure 1, represents the basic categorization of credit derivatives and the main types of credit derivatives. Unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. (The protection buyer, however, still may be exposed to the credit risk of the protection seller itself. This is known as counterparty risk.). 5 Figure 1 – The Categories and Types of Credit Derivatives Credit Derivatives Unfunded Credit Derivatives Funded Credit Derivatives - Credit default swap (CDS) - Credit-linked note (CLN) - Total return swap - Synthetic collateralized debt - Constant maturity credit default obligation (CDO) swap (CMCDS) - Constant Proportion Debt - First to Default Credit Default Swap Obligation (CPDO) - Portfolio Credit Default Swap - Synthetic Constant Proportion - Secured Loan Credit Default Swap Portfolio Insurance (Synthetic CPPI) - Credit Default Swap on Asset Backed Securities - Credit default swaption - Recovery lock transaction - Credit Spread Option - CDS index products Source: Fabozzi et al. (2004) and Author elaboration Credit derivatives have many potential benefits, in response to two long-standing problems in banking and risk management. First, lending operated under the restriction of hedging credit risk was impossible. The problem is that taking a short position in credit was not feasible. For instance, selling a sovereign bond short is only theoretically possible, many borrowers do not have liquid debt outstanding, so borrowing for a short sale is often impossible. A second problem was diversification of credit risk. Buying protection by means of credit derivatives provides solutions to both of the foregoing problems. By allowing banks to take a short credit position, credit derivatives enable banks to hedge their exposure to credit losses. 6 Another benefit of credit derivatives is that they add transparency to credit markets (Kroszner 2007). Prior to the existence of credit derivatives, determining a price for credit risk was difficult, and no accepted benchmark existed for credit risk. As credit derivatives become more liquid and cover a wider range of entities, however, lenders and investors will be able to compare pricing of cash instruments such as bonds and loans with credit derivatives. Further, investors will be able to engage in relative value trades between markets, which will lead to further improvements in efficiency and price discovery. At a higher level, economic stability stands to benefit from the ability to transfer credit risk by buying and selling protection. As with other derivatives, the cost of risk transfer is reduced, so risk is dispersed more widely into deeper markets. The result is that economic shocks should have less effect than was the case prior to the existence of derivatives. Several objections can be made to such an argument, however, and these will be considered in the next section. 7 3. Credit Default Swaps 3.1. Definition and Structure Credit Default Swaps are by far the most well-known and widely used type of credit derivatives for two main reasons (a) can be used as a standalone credit derivative in order to hedge or transfer credit