Now that financial – and particularly credit – markets have somewhat “normalized” with spreads having tightened in from their 2008-9 highs, financial engineers can re-focus their time to creating new products and services to “better manage risk, express views and enhance liquidity.” One of those new products which have garnered a renewed focus now that bankers have the time to work on it and markets are more open and accepting again of derivatives and structured financial products again is the contingent credit default swap (CCDS).
A CCDS is a type of derivative similar to a regular CDS except that the final notional amount is unknown at trade inception. The final notional amount of protection in a CCDS depends on more than one event or action to payoff – hence the term contingent.
The Wall Street Journal recently reported that the banking industry was trying to create an industry template for CCDS – particularly (CDS) index contingent credit default swaps as early as February 2011.
While there are theoretically any number of possible reference (contingent) transactions that a CCDS can be written to hedge including interest rates, currencies and commodities, the WSJ article highlights the interest-rate case to “mitigate the risk of a growing correlation between interest rates and risk premiums in the credit markets.”
The idea that rates and credit spreads are related was often ignored until it was highlighted by market volatility during the credit crisis. Now banks are highly sensitive to that relationship.
“The realized correlation since the beginning of the credit crisis has been negative. In other words, wider credit spreads have led to lower rates. But there is some fear that if all this aggressive quantitative easing fails, that correlation could reverse,” said a person familiar with the traders’ efforts……
Ordinary credit default swaps, or ‘CDS’, are derivatives that protect investors from the risk that a company fails to make repayments on a fixed amount of debt or files for bankruptcy, for example. Protection buyers receive an amount of compensation that is determined by the value assigned to the defaulted debt during an industry auction, after the contracts have been triggered for settlement.
Contingent CDS are similar to CDS in the sense that they reference bonds or loans and are triggered by a default. But unlike CDS their notional value–or the amount of protection bought and sold–is not fixed; it is determined by the fair market value assigned to another derivative, such as an interest rate swap.
Contingent CDS buyers would likely pay a percentage of the contract premium upfront, based on the value of the underlying swap, but no annual installments over the life of the swap. So for example, a quote of 0.05% would mean it would cost the buyer $5,000 upfront at inception.
The idea behind contingent CDS, or “CCDS,” is that banks may be doubly exposed as rates rise, because while they likely have hedges in place to cover their interest rate swap portfolio, the companies they lend to may have difficulty servicing their debts, and some may be worse off than others if inflation gets out of control.
While rising interest rates may mean the bank is in the money on its interest rate swap, its corporate counterparty may fall behind on debt repayments and have trouble meeting collateral calls on the swap.
“For a company susceptible to inflation, their creditworthiness will deteriorate as the [swap] trade goes into the money, so your exposure increases with that correlation. I might have a $10 million exposure that turns into a $50 million exposure as rates go up, so I need a contract where the amount of credit protection is tied to interest rates,” explained the person familiar with the project.
The International Swaps & Derivatives Association (ISDA) first published standardized confirmation documentation for CCDS in February 2007 as demand for the product emerged on the heels of Basel II and FAS 157 changes that required banks to better manage their counterparty risks. Basel II required banks to more dynamically set aside reserves to mitigate changes in the market risk of its different counterparties and CCDS initially became one of the tools that was believed to better manage that.
For example, Bank 1 may have entered into 2 of the same interest-rate swaps with 2 different banks, one an AAA-rated Bank 2 and the other a BBB-rated Bank 3. The issue, however, was that the ultimate payoffs on both of those “same” swaps could be different if the 2 different banks are not in strong enough of a financial condition to make good on the swap payments when the time comes due. Therefore, adding in a contingency in the swap determined by its credit risk or another entity’s credit risk provided a way to more dynamically hedge this counterparty risk rather than separately trying to buy and sell smaller amounts of regular CDS to delta-hedge or trying to issue collateral calls (or release collateral) on a daily basis to account for the daily changes in (perceived) credit risk. Counterparty Valuation Adjustments (CVA’s) are another product that are also used to help manage some of these risks.
CCDS does not necessarily need to be tied to interest-rates alone. Other cases where CCDS could potentially be used include hedging the relationship between energy companies or shippers and oil prices or steelmakers and coal prices.
CCDS are also not necessarily a “new” product. In 2009, for example, Citi said “that contingent credit default swaps referencing interest rates present an attractive opportunity in the current environment of low rates. The report says that far from being the expensive and illiquid exotic instruments that most investors perceive them to be, contingent CDS can in fact provide long-term credit and interest options that are otherwise hard to obtain.
More information on the theoretical and mathematical framework for understanding CCDS can be found in Jean Angbonou’s research piece entitled “Contingent Credit Default Swap: How To Manage Contingent Credit Risk”
Here is a small excerpt from the piece summarizing the mechanics:
C-CDS is designed as a perfect offset to counterparty credit exposure arising from a reference derivative. That is, it can be viewed and represented as a contract that is equal and opposite to an existing reference derivative, but without periodic cashflows. The notional on whichprotection has been purchased is easy to track and define; it’s simply the mark to market of the reference OTC derivative. The value of the C-CDS contract will change with changes in the market of the reference derivative as well as changes in the market’s perception of the reference entity’s credit quality.
In fact, a C-CDS for a reference derivative becomes more expensive as the credit spread of the reference entity widens. We also notice that a C-CDS for a reference entity becomes more expensive as the tenor of the reference derivative lengthens. Moreover, a C-CDS for a reference entity becomes more expensive as the amount of credit exposure in the reference derivative increases.
In the case of perfect correlation (r=1.0), the payoffs on a CCDS would be the same as a regular CDS – and perfect negative correlation would make a CCDS worthless and there is no chance of the contingent event occurring together. The following simplified diagrams from Bionic Turtle illustrate the case of a normal CDS and a CCDS (note though that in the case of a CCDS, the “CDS spread” will likely be an upfront payment rather than a running payment.
