CDS Pricing Conventions and Valuation Changes
Suppose a bond is trading at 98.71. What does that tell you about the credit risk of the issue?
That's right: nothing.
This could be a government issue. It could be a zero-coupon bond. It could be a high-yield bond with a high coupon. You really have no idea. But if you knew that the bond had a 5.2% spread over the government yield curve, then you'd know something about risk.
Not really; that's a fairly ambiguous term with no real evidence to support it.
No, this could actually _be_ a government bond.
Credit default swaps (CDS) are similar in this regard. Price doesn't tell you much, but the credit spread is informative. Price can be estimated with the duration of the CDS, but that's why price isn't directly useful.
Start with a five-year CDS with a 3% credit spread. The convention is to set up a 1% annualized coupon, letting the rest be captured in the upfront premium. That premium is estimated as
Upfront Premium = (Credit Spread - Fixed Coupon) $$\times$$ Duration.
What would you estimate the upfront premium to be?
No, that would require a duration of more than five years. This thing is all over in five years.
Exactly.
You can plug in the numbers, except for duration. For that, you need to recall that premiums end with a credit event, which may happen. So the duration will be something less than 5, depending on hazard rates. So maybe it's 4.5. In that case,
$$\displaystyle \mbox{Upfront Premium } = (0.03 - 0.01) \times 4.5 = 0.09 = 9 \% $$.
So the short, or the credit protection buyer, will pay an upfront premium of about 9% of notional.
Not quite; that would require a duration of five years. While it is a five-year CDS, think about the expectations built into the agreement.
From here, the value of the CDS per 100 par is 100 minus this upfront premium:
$$ \text{Price} = 100 - \text{Upfront Premium in %} = 100 - 9 = 91 $$.
Now the game begins. The 1% annualized coupon is put in place, and the long (credit protection seller) stands ready to compensate for a credit event. But probabilities change, and as they do, the value of the CDS changes with it. Suppose, for example, that the reference entity enjoys a credit upgrade. What do you think happens to the credit spread?
No, it will go down: better credit rating, less risk. Suppose that the credit spread drops from 3% to 2.5%.
Sure. Better rating, less risk. Suppose that the credit spread drops from 3% to 2.5%.
This lower credit spread means what should happen to the value of the CDS?
This lower credit spread means what should happen to the value of the CDS?
You're right again! Lower credit risk, lower spread, lower value to credit protection.
No, it's the same as last time. Lower credit risk, lower spread, lower value to credit protection.
Yes! This time you got it. Lower credit risk, lower spread, lower value to credit protection.
No, you were off both times. Lower credit risk means a lower spread, and then also a lower value to credit protection.
In fact, this can be calculated with a similar estimation. Since the upfront premium was found with the 2% difference multiplied by the duration, a CDS percentage price change is estimated with
$$\displaystyle \% \mbox{ Change in CDS Price} = \mbox{Change in Spread in bps} \times \mbox{Duration} $$.
The 50 bp decrease in this example, along with perhaps a duration of 4 since some time has passed, would suggest
$$\displaystyle \%\mbox{ Change in CDS Price} = -50 \times 4 = -200 $$.
This means a drop in price of 2% (200 bps), which is a profit to one party and a loss to the other of 2% of notional.
Who gets the profit?
Correct.
No, the long.
The long is the credit protection seller, and a safer reference entity means less risk of having to pay anything. The long wins.
If the credit protection seller wants to lock in this profit, or if the credit protection buyer wants to realize the loss, the parties can __monetize__ the gain or loss by just unwinding their position. The CDS market has some decent liquidity, so there's always another potential buyer or seller out there when you're ready to unwind.
To summarize:
[[summary]]
Nothing
It's high
It's greater than a government bond
Exactly 10%
Less than 10%
More than 10%
It goes up
It goes down
It should go up
It should go down
It should go up
It should go down
Long
Short
Continue
Continue
Continue
Continue
