Credit Risk in Derivatives Vs Fixed Income question, default, different, 201

LorrinCFA

Can someone help:

I seem to have conflicting definitions of credit risk and am worried that depending on where in the curriculum a question sits, a different one needs applying.

Reading 53 General Principles of Credit Analysis clearly states that the credit risk of a bond is made up of

1. default risk
2. credit spread risk
3. downgrade risk

Check out end of chapter question 1 page 201.

Reading 65 on using Credit Derivatives however, has a table showing how a CDS spread encapsulates 'pure credit risk' (page 357) but in the text -and logically- a CDS only prices default risk (given the definition of a credit event) and not credit spread risk nor downgrade risk. In theory anyway.

Have they dumbed it down slightly for reading 65 or have I answered my own question as they state 'PURE credit risk'. The doubt is then kept alive as the glossary says credit risk as being the same as default risk!

yodacaia

Ignore. I posted an answer then realized it was wrong.



Edited 1 time(s). Last edit at Monday, May 23, 2011 at 06:02PM by The+1Guy.

giorgio10

They have kind of dumbed it down a bit.

A CDS contract is basically an insurance contract on your bonds. It actually has technical language in the contract that says what events would constitute a default (ie. triggering event) like an out of bankruptcy court debt reorg (we swap out all our debt and issue new debt + equity because we are under water, etc.).

The way to think about it is that the COST of the CDS insurance contract reflects current credit risk. And the contract will PAY OFF in FULL in the event of a default (ie. bankruptcy, prepack bankruptcy, debt reorg.).

So when you look at a CDS that is say $500,000 per year on a $50 M set of bonds on JPMorgan and then it's $1.750 M for $50 M worth of insurance on a similar set of bonds for AIG, then you can see how the CDS costs you more for insurance on AIG. If there is a default event on JPMorgan/AIG your $500,000 or $1.75 M annual CDS cost will pay you $50 M total.

In the depths of the financial crisis you could basically buy a CDS and a bond and be guaranteed a risk free return well above where Rf rate was at, because the entire market was liquidity squeezed and had counterparty risks.

As a side note, this is how AIG blew themselves up. They sold a ton of CDS on various mortgages (collecting the premium) w/ the expectation that no one would ever default on their housing market en mass.

Also note, I have kind of dumbed this down. But hopefully it gives you some sense of how these things work. I find them to be pretty stupid contracts, personally... but finance people will invent and trade anything they can make a bet on.



Edited 2 time(s). Last edit at Monday, May 23, 2011 at 06:03PM by prophets.

zhaoyp

Hey Prohets, thank for the concise summary of CDS. Very useful but I still have the doubt. Not on CDS but on the definition to be used for Credit Risk depending on where in the curriculum I find myself.

I think I will just remember to make an exception if talking about CDS.