Structured Credit Products: basket credit default swaps

Credit derivatives are financial instruments that enable credit risk on a specified entity or asset to be transferred from one party to another. Hence they are used to take on or lay off credit risk, with one party being the buyer of credit protection and the other party being the seller of credit protection.

In a relatively short time they have become a key tool in the management of credit risk for banks as well as other capital market participants. The introduction of credit derivatives has resulted in the isolation of credit as a distinct asset class.

This has improved the efficiency of the capital market because market participants can separate the functions of credit origination and credit risk-bearing. Banks have been able to spread their credit risk exposure across the financial system, which arguably reduces systemic risk. They also improve market transparency by making it possible to better price specific types of credit risk.

The most common credit derivative is the credit default swap, credit swap or default swap. This is a bilateral contract that provides protection on the par value of a specified reference asset, with a protection buyer that pays a periodic fixed fee or a one-off premium to a protection seller, in return for which the seller will make a payment on the occurrence of a specified credit event.

The fee is usually quoted as a basis point multiplier of the nominal value. It is usually paid quarterly in arrears.

The swap can refer to a single asset, known as the reference asset or underlying asset, a basket of assets, or a reference entity. The default payment can be paid in whatever way suits the protection buyer or both counterparties.

For example it may be linked to the change in price of the reference asset or another specified asset, it may be fixed at a pre-determined recovery rate, or it may be in the form of actual delivery of the reference asset at a specified price.

Banks and other financial entities may use default swaps to trade sovereign and corporate credit spreads without trading the actual assets themselves. The original buyer of the default swap need never have owned a bond issued by the reference asset obligor.

We look now at a variation on the basic CDS, the basket CDS, widely used in structured finance.

Basket default swap

The simplest CDS is the single-name credit default swap, which references one reference entity or the specific asset of an entity. A basket default swap is linked to a group of reference entities. There may be five, 10, 20 or more reference names in the basket.

While it is possible to buy a CDS that covers all the named assets in the event of default, this is rare and the most common basket CDS provide protection on a selection of the names in the basket only. For instance, if there are q names in the basket, the basket CDS may be one of the following:

• first-to-default, which provides credit protection on the first default in the basket only;
• second to default, which provides credit protection on the second default in the basket (but not the first);
• n-th to default, which provides protection on the first n (out of q) defaults in the basket;
• last p-th to default, which provides protection on the last p (out of q) defaults.

Illustration of a Basket Credit Default Swap

Figure 1 shows a basket credit default swap written on a portfolio of five reference names. The protection seller writes protection on the basket, for which it receives the CDS premium.

A notional amount is specified for each reference entity in the basket, During the term of the CDS if one of the reference entities experiences a credit event, the protection seller will make a protection payment to the protection buyer, to the value of the pre-specified notional amount (minus the usual value in accordance with the type of settlement mechanism chose. On occurrence of a credit event, the affected reference entity is removed from the basket. However the CDS itself still runs to its original maturity date, covering the remaining entities in the basket.

Figure 1 Basket CDS

As an example consider a basket CDS as shown in Figure 1, written on a portfolio of five reference entities. A protection buyer enters into a basket CDS with a market maker with the following terms:

Assume that one year into the transaction, one of the reference entities experiences a credit event. Its recover value is determined to be 70%. The protection seller makes a payment of $20 million x (1.00 - 0.70) or $6 million at the time of the credit event. The affected reference name then drops out of the basket.

The CDS will then continue to maturity, and assuming the portfolio experienced no further credit evens, would expire on 19 February 2009 having not paid out any more cash flows (apart from the ongoing premium). The terms of the CDS would have changed to reflect a USF 80 million notional basket value, covering four reference entities.

If any of the remaining four entities experience a credit event, the same procedure will apply again. The main difference between a single name CDS and the basket is that the CDS would have terminated on occurrence of the credit event, whereas the basket will continue, albeit covering only for the remaining unaffected names, to its original maturity date.

The key advantage of the basket CDS is that it typically offers protection for multiple names at a lower cost than if the protection buyer had taken out a series of single-name CDS for each name in the portfolio.

The protection provided by the basket discussed above could also be traded in funded form, as a basket credit-linked note (CLN). In the example given above, the nominal value of the note would be $200 million, paid up front by the investor (protection seller).

If we assume the same credit event as above, there will be a payout on occurrence of the credit event of $6 million, and on maturity of the note (assuming no further credit events) the redemption proceeds would be $180 million rather than $200 million. Investors receive a pro rata amount of the remaining total principal available in accordance with the amount of the note they are holding.

If the CLN was issued as a series of notes with differing seniority, the senior notes would be paid off in full first before investors holding the more junior notes are paid their redemption proceeds.

The basket CLN is shown in Figure 2.

Figure 2 Basket CLN

First to Default Portfolio CDS

A first-to-default CDS (FtD) is similar to the basket CDS described above, with one key difference: unlike with a standard basket CDS, on occurrence of a credit event the entire FtD CDS will terminate and settlement will be with regard to the entire notional amount following the first credit event affecting one of the reference entities.

If we assume the same circumstances as the earlier basket CDS, with the FtD CDS written on five reference entities for a notional total of $200 million, following the first credit event the swap will terminate with a settlement of $186 million.

The key issue for those analysing FtD swaps is the correlation between the different reference entity names. Correlation is assessed with respect to each name's industrial sector, credit rating, geographical region and so on.

In contrast to an investor in (say) a cash flow CDO, where diversifying among the names in the portfolio will reduce the risk exposure to the credit protection seller, with an FtD CDS greater diversity may in fact increase the risk factor.

This is because it may increase the probability of default or other credit event, since as soon as the first reference entity to experiences a credit event, it triggers termination of the entire CDS. For this reason, a FtD CDS will be priced at a higher level than a basket CDS for the same reference name, to compensate investors for the higher resultant risk exposure.

Moorad Choudhry is Visiting Professor at the Department of Economics, London Metropolitan University, and author of Structured Credit Products, Analysing and Interpreting the Yield Curve, The Global Repo Markets and Fixed Income Markets (Wiley 2004)

To see more finance related titles from Wiley Publishers, please click here.