Question

This question is about credit derivatives

1) Illustrate the framework Credit Default Swap (CDS).

2) Bank A makes a USD 10 million five-year loan and wants to offset the credit exposure to the obligor. A five-year credit default swap (CDS) with the loan as the reference asset trades on the market at a swap premium of 50 basis points (annual rate) paid quarterly. In order to hedge its credit exposure, what should bank A do? (Detail the payment if bank A uses CDS).

3) Illustrate the framework of total return swaps

4) Helman Bank has made a loan of USD 300 million at 7% per annum. Helman enters into a total return swap under which it will pay the interest on the loan plus the change in the marked-to-market value of the loan, and in exchange Helman will receive LIBOR + 50 basis points. Settlement payments are made annually. What is the cash flow for Helman on the first settlement date if the mark-to-market value of the loan falls by 2% and LIBOR is 4%?

5) Discuss the difference between Credit Default Swap and Total Return Swap in terms of hedging credit risk and market risk

		Standard	Normal		Distribution
n	1	1.25	1.65	2	2.33	2.55
Prob(X<n)	84%	90%	95%	97.5%	99%	99.5%

Answer 1

Ans

The credit default swap is an exchange between two counterparties of a fee in exchange for a payment if a “credit default event” occurs.

Here one party say company A(also known as protection buyer) pays premium to company B(known as protection seller) who in return will compensate to company A if it suffers a loss on account of default by third party who owes money to company A on account of contractual obligation.

The important components in CDS are:-

1)Reference Asset- Asset on which the protection is bought, often it is a loan, a bond or even a basket of those.

2)The maturity of the swap- This is the period over which the protection is in effect.

3)Credit events- These are the events whose realization means default of the reference entity.

4)Premium payments - These are the payments that the protection buyer pays to the protection seller in return for this protection

5)Default payment: This is the payment the protection seller is obligated to provide to the protection buyer if the default occurs.

2) If bank opts to hedge its credit exposure, it should purchase the credit default swaps of 5 year will loan has its reference asset so if the bank incurres loss on account of default by the borrower of refernce asset(loan) , it can seek compensation from the protection seller.

For hedging the CDS, bank will have to make quarterly premium of $125000 (i.e 0.50/4 x $10Mns)

3)A total Return Swap is a contract between two parties who exchange the return from a financial assetbetween them. In this agreement, one party makes payments based on a set rate while the other party makes payments based on the total return of an underlying asset. The underlying asset may be a bond, equity interest, or loan

In the TRS, there are two parties a payer who will be a bank or hedge fund and the receiver.

Receiver will pay to the payer at set rate say LIBOR + fixed margin .

While payer will pay to receiver the interest income on the underlying asset plus the loss receiver incurs on account of reduction in value of underlying asset.(Payer wil not pay to receiver on account of increase in value of asset)

Thus it insures the receiver against the loss on account of decilne in value of asset. For protecting the same it has to pay interest based on the contract between the payer and receiver.

4)

Inflow	$(In Mns)
Interest on loan	21
LIBOR + 50 BASIS Points	14
	34.5
Outflow
Decline in value of loan	6
Interest on Loan	21
	27
Net Cash Inflow	7.5