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61-403: CPPI products on a variety of risky assets have been sold by financial institutions, including equity indices and credit default swap indices. Constant proportion portfolio insurance (CPPI) was first studied by Perold (1986) for fixed-income instruments and by Black and Jones (1987), Black and Rouhani (1989), and Black and Perold for equity instruments. In order to guarantee the capital invested,

122-528: A hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $ 10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500 basis points (=5%) per annum. Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses. For example: Transactions such as these do not even have to be entered into over

183-429: A CDS as a hedge for similar reasons. Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of $ 10 million. To manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $ 10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection,

244-570: A CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral . The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require payment of an upfront fee (composed of "reset to par" and an "initial coupon."). Another kind of risk for

305-495: A CDS, both the buyer and seller of credit protection take on counterparty risk : In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/ clearing house , such as ICE TCC, there will no longer be "counterparty risk", as the risk of the counterparty will be held with the central exchange/clearing house. As is true with other forms of over-the-counter derivatives, CDS might involve liquidity risk . If one or both parties to

366-954: A CPPI strategy across investment period [ t , T ] {\displaystyle [t,T]} are μ C P P I = F / V e r t − r T V + C e T r + T m μ − T m r {\displaystyle \mu _{CPPI}={\frac {F/V}{e^{rt-rT}}}V+Ce^{Tr+Tm\mu -Tmr}} σ C P P I 2 = C 2 e 2 T ( r + m μ − m r ) ( e T m 2 σ 2 − 1 ) {\displaystyle \sigma _{CPPI}^{2}=C^{2}e^{2T(r+m\mu -mr)}\left(e^{Tm^{2}\sigma ^{2}}-1\right)} where μ {\displaystyle \mu } and σ 2 {\displaystyle \sigma ^{2}} are

427-407: A bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default . Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular. Because the speculator in either case does not own the bond, its position is said to be a synthetic long or short position. For example,

488-537: A company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve. The investor selling the CDS is viewed as being " long " on the CDS and the credit, as if the investor owned the bond. In contrast, the investor who bought protection is " short " on the CDS and the underlying credit. Credit default swaps opened up important new avenues to speculators. Investors could go long on

549-531: A credit event. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's credit rating . CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium, and acceleration. Most CDSs are in

610-487: A function of the notional leveraged exposure. Fundamentally, the CPPI strategy can be understood as V r i s k y = m ⋅ ( V − F ) {\displaystyle V_{risky}=m\cdot (V-F)} where V r i s k y {\displaystyle V_{risky}} is the value of assets in the risky portfolio, V {\displaystyle V}

671-403: A gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses ). If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur: The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of

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732-494: A huge incentive for arson. Analogizing to the concept of insurable interest , critics say you should not be able to buy a CDS—insurance against default—when you do not own the bond. Short selling is also viewed as gambling and the CDS market as a casino. Another concern is the size of the CDS market. Because naked credit default swaps are synthetic, there is no limit to how many can be sold. The gross amount of CDSs far exceeds all "real" corporate bonds and loans outstanding. As

793-419: A lack of transparency. A CDS can be unsecured (without collateral) and be at higher risk for a default. A CDS is linked to a "reference entity" or "reference obligor", usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the "spread" charged in basis points by the seller to insure against

854-414: A particular credit risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under Basel I ). This frees resources the bank can use to make other loans to the same key customer or to other borrowers. Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy

915-404: A party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no customer base. A bank buying protection can also use a CDS to free regulatory capital. By offloading

976-531: A portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of mortgage-backed securities . In

1037-432: A ratio of x:y:100%-x-y as the third asset is the safe and riskless equivalent asset like cash or bonds. At the end of each period, the exposure is rebalanced. Say we have a note of $ 1 million, and the initial allocations are 100k, 200k, and 700k. After period one, the market value changes to 120k:80k:600k. We now rebalance to increase exposure on the outperforming asset and reduce exposure to the worst-performing asset. Asset A

1098-465: A result, the risk of default is magnified leading to concerns about systemic risk. Financier George Soros called for an outright ban on naked credit default swaps, viewing them as "toxic" and allowing speculators to bet against and "bear raid" companies or countries. His concerns were echoed by several European politicians who, during the Greek government-debt crisis , accused naked CDS buyers of making

1159-548: Is "$ 8 trillion notional value outstanding" as of June 2018. Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives Association (ISDA) , although there are many variants. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called credit-linked notes ), as well as loan-only credit default swaps (LCDS). Further, in addition to corporations and governments,

1220-828: Is available from S&P Capital IQ through their acquisition of Credit Market Analysis in 2012. According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts outstanding in the marketplace." The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S commercial banks and trust companies. Credit default swaps can be used by investors for speculation , hedging and arbitrage . Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as

1281-479: Is no required reporting of transactions to a government agency. During the 2007–2008 financial crisis , the lack of transparency in this large market became a concern to regulators as it could pose a systemic risk . In March 2010, the Depository Trust & Clearing Corporation (see Sources of Market Data ) announced it would give regulators greater access to its credit default swaps database. There

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1342-402: Is often substantially less than the face value of the loan. Credit default swaps in their current form have existed since the early 1990s and increased in use in the early 2000s. By the end of 2007, the outstanding CDS amount was $ 62.2 trillion, falling to $ 26.3 trillion by mid-year 2010 and reportedly $ 25.5  trillion in early 2012. CDSs are not traded on an exchange and there

1403-437: Is that CPPI protection is much cheaper and less impacted by market movements. A variation of CPPI is the so-called Time Invariant Portfolio Protection Strategy (TIPP) where the capital is (partially) protected continuously (typically on a daily basis) as opposed to a protection at a fixed date in the future. The bond floor is the value below which the value of the CPPI portfolio should never fall in order to be able to ensure

1464-433: Is that without default risk, a bank may have no motivation to actively monitor the loan and the counterparty has no relationship to the borrower. Another kind of hedge is against concentration risk. A bank's risk management team may advise that the bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS. Because the borrower—the reference entity—is not

1525-400: Is the best performer, so its rebalanced to be left at 120k, B is the worst performer, to its rebalanced to 60k, and C is the remaining, 800k-120k-60k=620k. We are now back to the original fixed weights of 120:60:620 or ratio-wise 2:1:remaining. Credit default swap A credit default swap ( CDS ) is a financial swap agreement that the seller of the CDS will compensate the buyer in

1586-438: Is the starting value of assets in the total portfolio, F {\displaystyle F} is the asset level below which the total portfolio should not fall, and m ≥ 1 {\displaystyle m\geq 1} is the multiplier. Because the percentage of the portfolio invested in the risky asset at any given time can vary, the dynamics of a CPPI strategy are complex. The average return and variance of

1647-476: The 2007–2008 financial crisis , most observers conclude that using credit default swaps as a hedging device has a useful purpose. Capital Structure Arbitrage is an example of an arbitrage strategy that uses CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it

1708-441: The face value of the loan), and the seller of the CDS takes possession of the defaulted loan or its market value in cash. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction . The payment received

1769-420: The notional amount . For example, if the CDS spread of Risky Corp is 50 basis points , or 0.5% (1 basis point = 0.01%), then an investor buying $ 10 million worth of protection from AAA-Bank must pay the bank $ 50,000. Payments are usually made on a quarterly basis, in arrear . These payments continue until either the CDS contract expires or Risky Corp defaults. All things being equal, at any given time, if

1830-568: The $ 10–$ 20 million range with maturities between one and 10 years. Five years is the most typical maturity. An investor or speculator may "buy protection" to hedge the risk of default on a bond or other debt instrument, regardless of whether such investor or speculator holds an interest in or bears any risk of loss relating to such bond or debt instrument. In this way, a CDS is similar to credit insurance , although CDSs are not subject to regulations governing traditional insurance. Also, investors can buy and sell protection without owning debt of

1891-400: The CPPI provides leverage through a multiplier. This multiplier is set to 100 divided by the crash size (as a percentage) that is being insured against. For example, say an investor has a $ 100 portfolio, a floor of $ 90 (price of the bond to guarantee his $ 100 at maturity) and a multiplier of 5 (ensuring protection against a drop of at most 20% before rebalancing the portfolio). Then on day one,

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1952-692: The North American CDX index or the European iTraxx index. An investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by entering into a trade, known as a basis trade , that combines a CDS with a cash bond and an interest rate swap . Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on

2013-421: The average return and variance of the risky asset, respectively, and C = ( 1 − F / V e r t − r T e − r T ) V {\displaystyle C=\left(1-{\frac {F/V}{e^{rt-rT}}}e^{-rT}\right)V} . In some CPPI structured products, the multipliers are constant. Say for a 3 asset CPPI, we have

2074-402: The bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely damage the banker-client relationship. In addition, the bank simply may not want to sell or share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. The downside to this hedge

2135-414: The beneficial effect of increasing liquidity in the marketplace. That benefits hedging activities. Without speculators buying and selling naked CDSs, banks wanting to hedge might not find a ready seller of protection. Speculators also create a more competitive marketplace, keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer to regulators and investors about

2196-426: The best indicators of the likelihood of sellers of CDSs having to perform under these contracts. CDS contracts have obvious similarities with insurance contracts because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs. However, there are also many differences, the most important being that an insurance contract provides an indemnity against the losses actually suffered by

2257-426: The bill did not become law. Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt. There are other ways to eliminate or reduce

2318-739: The credit default swaps market is available from three main sources. Data on an annual and semiannual basis is available from the International Swaps and Derivatives Association (ISDA) since 2001 and from the Bank for International Settlements (BIS) since 2004. The Depository Trust & Clearing Corporation (DTCC), through its global repository Trade Information Warehouse (TIW), provides weekly data but publicly available information goes back only one year. The numbers provided by each source do not always match because each provider uses different sampling methods. Daily, intraday and real time data

2379-469: The credit health of a company or country. Germany's market regulator BaFin found that naked CDS did not worsen the Greek credit crisis. Without credit default swaps, Greece's borrowing costs would be higher. As of November 2011, the Greek bonds have a bond yield of 28%. A bill in the U.S. Congress proposed giving a public authority the power to limit the use of CDSs other than for hedging purposes, but

2440-578: The crisis worse. Despite these concerns, former United States Secretary of the Treasury Geithner and Commodity Futures Trading Commission Chairman Gensler are not in favor of an outright ban on naked credit default swaps. They prefer greater transparency and better capitalization requirements. These officials think that naked CDSs have a place in the market. Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has

2501-399: The drawback is that whenever a trade event to reallocate the weights to the theoretical values happen, the prices have either shifted quite a bit high or low, resulting in the CPPI effectively buying (due to leverage) high and selling low. As dynamic trading strategies assume that capital markets trade in a continuous fashion, gap risk is the main concern of CPPI writer, since a sudden drop in

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2562-475: The equity and the remainder in the zero coupon bond. A measure of the proportion of the equity part compared to the cushion, or (CPPI-bond floor)/equity. Theoretically, this should equal 1/multiplier and the investor uses periodic rebalancing of the portfolio to attempt to maintain this. If the gap remains between an upper and a lower trigger band (resp. releverage and deleverage triggers), the strategy does not trade. It effectively reduces transaction costs , but

2623-418: The event of a debt default (by the debtor) or other credit event . That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, may expect to receive a payoff if the asset defaults. In the event of default, the buyer of the credit default swap receives compensation (usually

2684-645: The examples above, the hedge fund did not own any debt of Risky Corp. A CDS in which the buyer does not own the underlying debt is referred to as a naked credit default swap , estimated to be up to 80% of the credit default swap market. There is currently a debate in the United States and Europe about whether speculative uses of credit default swaps should be banned. Legislation is under consideration by Congress as part of financial reform. Critics assert that naked CDSs should be banned, comparing them to buying fire insurance on your neighbor's house, which creates

2745-400: The investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge . But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in

2806-432: The long-term. If Risky Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts. Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure to

2867-438: The low risk asset until the product matures. CPPI strategies aim at offering a capital protection to its investors. Compared to a bond + call strategy, the drawback of the CPPI is that it follows a buy high sell low strategy. Volatility will hurt the performance of the investment, and once the strategy has deleveraged, it never recovers and the investors have to wait until maturity to receive their initial investments. The benefit

2928-463: The maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be

2989-425: The payment of all future due cash flows (including notional guarantee at maturity). Unlike a regular bond + call strategy which only allocates the remaining dollar amount on top of the bond value (say the bond to pay 100 is worth 80, the remaining cash value is 20), the CPPI leverages the cash amount. The multiplier is usually 4 or 5, meaning you do not invest 80 in the bond and 20 in the equity, rather m*(100-bond) in

3050-403: The pension fund pays 2% of $ 10 million ($ 200,000) per annum in quarterly installments of $ 50,000 to Derivative Bank. In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables. Although credit default swaps have been highly criticized for their role in

3111-422: The policy holder on an asset in which it holds an insurable interest . By contrast, a CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. The holder does not need to own the underlying security and does not even have to suffer a loss from the default event. The CDS can therefore be used to speculate on debt objects. The other differences include: When entering into

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3172-429: The position from the risky assets to the bond, leading the structure to a state where it is impossible to guarantee principal at maturity. With this feature being ensured by contract with the buyer, the writer has to put up money of his own to cover for the difference (the issuer has effectively written a put option on the structure NAV). Banks generally charge a small "protection" or "gap" fee to cover this risk, usually as

3233-529: The reference entity can include a special purpose vehicle issuing asset-backed securities . CDS data can be used by financial professionals , regulators, and the media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies . Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with

3294-474: The reference entity. These "naked credit default swaps" allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, CDSs can also be used in capital structure arbitrage . A "credit default swap" (CDS) is a credit derivative contract between two counterparties . The buyer makes periodic payments to

3355-411: The risk of default. The bank could sell (that is, assign) the loan outright or bring in other banks as participants . However, these options may not meet the bank's needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants. If both the borrower and lender are well-known and the market (or even worse, the news media) learns that

3416-434: The risky asset may vary during the life of the product. In case the active asset performance is negative, the values of the active asset and the CPPI strategy will decrease, and as a result the allocation of the strategy to the active asset will decrease. Should the exposure to the risky asset drop to zero or a very low level, then the CPPI is said to be deleveraged or cashed out. The CPPI strategy will then be fully allocated to

3477-407: The risky underlying trading instrument(s) could reduce the overall CPPI net asset value below the value of the bond floor needed to guarantee the capital at maturity. In the models initially introduced by Black and Jones Black & Rouhani, this risk does not materialize: to measure it one needs to take into account sudden moves (jumps) in prices. Such sudden price moves may make it impossible to shift

3538-479: The seller of portfolio insurance maintains a position in a treasury bonds or liquid monetary instruments, together with a leveraged position in an "active asset", which constitutes the performance engine. Examples of risky assets are a basket of equity shares or a basket of mutual funds across various asset classes. While in the case of a bond+call , the client would only get the remaining proceeds (or initial cushion) invested in an option, bought once and for all,

3599-416: The seller of credit default swaps is jump risk or jump-to-default risk ("JTD risk"). A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives. Data about

3660-507: The seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event . The CDS may refer to a specified loan or bond obligation of a "reference entity", usually a corporation or government. As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt,

3721-413: The writer will allocate (5 * ($ 100 – $ 90)) = $ 50 to the risky asset and the remaining $ 50 to the riskless asset (the bond). The exposure will be revised as the portfolio value changes, i.e., when the risky asset performs and with leverage multiplies by 5 the performance (or vice versa). Same with the bond. These rules are predefined and agreed once and for all during the life of the product. The allocation to

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