Credit Default Swap, or CDS, is an instrument which is used to insured an exposure against a default. When a bank lends credit to an obligor and this obligor is unable to make the payment on time, it is a credit event or default. When a default happens, then the CDS counterparty (the protection seller) pays the bank an agreed sum called notional amount.

For this service the bank pays the counterparty a fee, which is called CDS spread. This is usually paid upfront and annually. One company that publishes CDS prices is Markit, http://www.markit.com. Markit also publishes the CDS Implied Rating, which is the S&P style of credit reliability of an entity, determined from their CDS price. The higher the price, the lower the rating, because it means that it is more likely that the company will default.

The CDS spreads is noted not as an absolute figure, but relative to the notation. For example, if the notation is USD 10 million, and the spread is 1%, then the fee that the lender needs to pay is $1m x 1% = $10,000. But a CDS spread is not noted in percentage. It is written in basis points, or bps, which is 1 percent divided by 100. So 1% is 100 bps, 2% is 200 bps, and so on. The notional amount is the maximum amount in which we are protected against. For example, if our exposure is $100m, and we buy a CDS with limit of $20m, then the counterparty will only pay us $20m in the event of obligor default.

There is a difference between the market spread and the traded spread. A market spread is the price of a CDS for that referenced entity that the publicly traded on that day. Of course the market spread will depend on the tenor. A tenor is the duration of coverage in which the CDS is active. For example, we can buy a CDS which lasts for 1 year, 3 years, 5 years, or 10 years. The longer the tenor, the higher the spread. Tenor is determined from the maturity date minus effective date. A traded spread is the price that we actually paid when we buy or sell the CDS, which can be above or below the market price on that day.

The obligor which the bank protected against is called the referenced entity. A referenced entity is usually a single name. And this single name is usually a legal entity, i.e. it is incorporated as company, a partnership (LLP), a government, an individual or a municipal which is a department in a local or national government.

In contrast to a single name CDS, we also have a CDS index, which is an amalgamation of several CDSes. Two famous indices are iTraxx and CDX. For example, we have an index for financial services company in Europe. Rather than buying several CDSes for individual companies, we buy a CDS Index for European banks which should lower the cost. If any of the constituent company in the index goes default, the seller pays the protection buyer. The pricing of a CDS Index could be tricky because different obligor has different credit rating, and different likelihood of going default.

ITraxx covers the following sectors: financials (senior and sub), non financials, TMT (telcom, media, tech), industrials, energy, consumers, automotive. Benchmark: top 123 companies, top 30 high volatility, 40 top crossover (between investment grades and junk/high yield).

CDX covers the following: CDX.NA.IG: investment grade, CDX.NA.IG.HVOL: Investment grade but high volatility, CDX.NA.HY: high yield, CDX.NA.HY.BB, B, XO (crossover), EM (Emerging Market), LCDX (Loan only)

CDS has seniority level. Senior Unsecured Debt (for corporate) or for a government it’s Foreign Currency Sovereign Debt is the most senior. Subordinated or Lower Tier 2 Debt has lower seniority. There is also Junior Subordinated or Lower Tier 1 which is even lower in seniority. CDS with higher seniority level has higher prices.

Recovery rate of a CDS reflects the amount that the lender might get back at the credit events. Recovery rate depends on the seniority. The more senior a CDS is, the higher the recovery rate. ISDA (the international body that governs the standards of CDS) assumes that the recovery rate for a senior unsecured (SNRFOR) is 40%, subordinate (SUBLT2) is 20%, and for emerging market (both senior and subordinate) is 25%. The final payment from the seller is the calculated as notional minus the amount recovered (which is recovery rate x notional). ISDA stands for International Swap and Derivative Association.

There two settlements: cash settlement and physical settlement. Physical settlement is where the buyer gives the seller the bonds that they are holding, and the seller pays the notional value (whole amount/par). Cash settlement is where the seller pays the buyer the notional minus the recovered amount (= recovery rate x notional). These days, most CDS are bought/sold not for hedging, but to take a position on credit, so cash settlement is preferred.

The recovery rate is determined in an auction, usually run by Markit or Creditex. A primer on CDS Auction is here, which is a must read. And the formal rules of CDS Auctions are determined by ISDA, here. There are 2 stages:

Stage 1. All dealers submit their bid and offer, at agreed spread and quotation size, and at agreed precision (usually 0.125%). They also submit their physical settlement requests. From these we calculate the Initial Market Midpoint (IMM), and the adjustment amount. And we calculate the open interest, which is the total of the physical settlement requests.

Stage 2: All dealers submit their new bids and offers, which is added to the bids and offers in stage 1. Any bids above IMM + ½ spread is set to IMM + ½ spread.

Check how many bids needed to cover open interest. Say we need four bids to cover the open interest. Then the final price is the lowest of these four. The final price is the recovery rate, the amount the investors get back from the defaulted bonds.

Restructuring. When an obligor defaulted, they restructure their debt. For the same entity, same tenor, same seniority, and same coupon (see below), we have different restructuring mechanism for which the CDS covers for. This is known as the document clause. We have NR (no restructuring, old restructuring, modified restructuring and modified-modified Restructuring). The market price of a CDS depends on: entity, date, tenor, coupon, seniority, document clause and currency. A CDS traded in EUR may have different market spread to JPY.

CDS big bang (read document from Markit, link): We have 2 elements of payments: fixed coupon and upfront payment. Coupon is the payment that the buyer pays every quarter, stated in bps. Coupon is usually either 100 or 500 bps. On top of the coupon, the buyer also pays an upfront payment, also stated in bps.

Conventional Spread is the CDS prices for CDS with coupon of 100 bps. Whereas CDS with coupon of 500 bps will be quoted (generally) with upfront payment. Buyers pays the coupon in full on the first payment date. So we need to calculate the accrual rebate payment to the buyer at the time of the trade.

CDS Curve is a series of CDS spread across different tenors/years.

Traditionally, the purpose of buy or selling a CDS is to remove asset from balance sheet, to meet regulatory capital requirement/liquidity, improve risk of capital, ROE, ROEC. Basically to off load credit risk from balance sheet. But now a days banks trade CDS to take position on credit risk, not to hedge a portfolio.

DTCC is the clearing house for CDS. It stands for Depository Trust and Clearing Corporation. Their function is not just covering CDS, but also equity and fixed income.

CDO is collateralised debt obligation. It’s an asset backed security with multiple tranches (seniority / risk classes), collateralized by loans or bonds. Junior and equity tranches offer higher coupon and interest rates to compensate the default risk. There are 4 types: CLO (Loan), CBO) (Bonds), CSO (Synthetic/CDS), SFCDO (structured products, i.e. mortgages/MBS, ABS)

Value at Risk: is the risk of loss for a portfolio, for a time horizon and probability.

Interest rate risk: risk of decreasing revenue of bond, loan because of interest rate raise/fall. Basis risk: LIBOR and US prime rate moving in different direction. Yield curve risk: different between short term and long term interest rates. Repricing risk: when interest rate fall, loan with variable rate will generate lower interest income.

Main sources: Wikipedia, Markit web site, ISDA web site.

Thank you very much for the explanation. Three questions:

1. You wrote, “The CDS spreads is noted not as an absolute figure, but relative to the notation. For example, if the notation is USD 10 million, and the spread is 1%, then the fee that the lender needs to pay is $1m x 1% = $10,000. ”

Should that be $10m x 1% = $100,000?

2. Is the fee an annual or one-time payment for the 5 years of protection (for a 5-year CDS)?

3. What is the difference between quoting as a “conventional spread” and an “upfront spread”?

Thank you very much.

Comment by Michael Ash — 27 May 2015 @ 5:33 pm |

Hi Michael,

1. Yes you are right it should be $100k. Apologies for the error.

2. The fee is annual, not one off. In the example on point 1 above, each year they need to pay $100k, for 5 years. This payment is paid quarterly, i.e. $25k on 20th March, $25k on 20th June, $25k on 20th Sep, $25k on 20th Dec. These are ISDA standard days.

3. Difference in usage: Quoting in “conventional spread” is usually done for less risky CDS (low bps, i.e. IG ones), quoting in “upfront” is usually done for risky CDS (high bps, i.e. HY ones). Difference in meaning: upfront quote is Cash Settlement plus Accrued Premium (divided by Notional) so it is easier to understand the cash flow compared to the conventional spread quote.

Kind regards,

Vincent

Comment by Vincent Rainardi — 28 May 2015 @ 7:52 am |

Thank you — this was a very helpful response (and an excellent article). I’m still a little confused by conventional spread vs. upfront spread. You gave the example of 1 percent, i.e., 100 bps, per year for five years. I think that 100 bps is “conventional spread”. Can you please convert this to upfront spread (just for exposition, even if “conventional” would be the standard for the less risky CDS in this example)? Thanks again.

Comment by Michael Ash — 28 May 2015 @ 9:30 am

Hi Michael, let’s take this example. A 5 year CDS has a notional of $1m. It is trading at 250 bps. This 250 bps is the “conventional spread” quote.

We are buying this CDS. So we will be paying $25k (250 bps) each quarter to the seller.

But since 2009 there is no CDS at 250 bps. They are all either 100 bps or 500 bps (In Europe we also have 25 and 1000 bps). Let’s say that this one is 100 bps. This is annual payment amount called “coupon”.

So, we agree that we are buying it at 250 bps ($25k), but we agree we will pay 100 bps ($10k) each quarter. To close this 150 bps gap, we pay $52,500 (5.25%) upfront (when we buy the CDS). This 5.25% is the “upfront” quote.

How is this 5.25% upfront payment calculated from the 250 bps spread?

First we calculate the PV01 (Present Value of point zero one percent / 0.01%). PV01 is the present value of 1 basis point of coupon payment in each quarter, for the duration of 5 years. In the above case the PV01 is 3.5 bps ($350). So if each quarter we pay 1bp ($100) to the seller for 5 years, the value of all those 20 payments today is $350 (3.5 bps). The formula to calculate this PV01 of 3.5 bps is: sum of (discount factor x survival probability x day count fraction) on each date. The present value of the payments in year 5 is bigger than the present value of the payments in year 1. And this PV01 is the sum of the present value of all 20 payments (4 payments per year for 5 years) of 1 bp each.

Once we have PV01, we can calculate the upfront payment as follows:

Upfront = (Spread – Coupon) x PV01 = (250 – 100) x 3.5 = 150 x 3.5 = 525 bps = 5.25%

There are a few assumptions for this formula, such as the Recovery Rate is 40%. See the “ISDA Standard CDS Contract Converter Specification” on http://www.cdsmodel.com for complete list of assumptions and the exact details of the calculation.

Hope this helps. Vincent

Comment by Vincent Rainardi — 28 May 2015 @ 7:43 pm

Thank you once again — that was very clear. A last question: how do we get the discount rate needed to make the two quote methods equivalent? In the example you gave, where 5 years of 1 bp has a present discounted value of 3.5 bps, the implied discount rate is 13.2 percent. I.e. a discount rate of 13.2 percent makes the conventional quote 250 bps @ 100 equivalent to the upfront quote of 5.25%+100. In general, what’s the source of the discount rate, and wouldn’t one need to know the discount rate in order to translate conventional and upfront quotes? Thanks.

Comment by Michael Ash — 29 May 2015 @ 3:04 pm

Hi Michael, the discount rate is from ICE LIBOR rates for tenor less than 1 year, and ICE swap rates for tenor more than 1 year, published by ICE here: https://www.theice.com/iba/historical-data

Comment by Vincent Rainardi — 30 May 2015 @ 6:12 am

Thank you.

Comment by Michael Ash — 1 June 2015 @ 10:37 am

Quick question please, Could the recovery rate of a SUBLT2 CDS be higher than the SNRFOR tier?

Comment by James Charles — 16 January 2017 @ 4:44 pm |

Apologies I don’t know the answer for sure James (my unsure answer is: not in normal circumstances, but I guess it is still possible)

Comment by Vincent Rainardi — 16 January 2017 @ 6:45 pm |