Credit Default Swap- ||

In last post, Credit Default Swap - I, we discussed the basics of CDS and how we can replicate risk and return profile of CDS using the bond , repo and asset swap market instruments.

Following transaction needs to be done for replicating the short CDS portfolio.

1) Buy a par bond, the one which currently trading at par.
2) Fund purchase of  above bond using the repo transaction (long on credit risk without need of extra liquidity)
3) Asset swap spread transaction to exchange the fixed coupon with floating rate (Libor + spreads). This transaction will hedge the interest rate risk of bond. Bond + asset swap spread portfolio will have exposure to only credit risk of bond.


                

Funding Cost differences- 
Funding cost in repo market depend on the market participants. Funding cost can be less than Libor for a top quality borrower or it can be less than Libor for others. These cost differentials result in a breakdown of the one-to-one relationship, and introduce a theoretical range around the cash spread within which CDS may trade.

CDS spread from the above replication portfolio for top quality borrower  = (Libor +ASW Spread) - (Libor - Repo spread)
CDS spread from the above replication portfolio for other borrower = (Libor +ASW Spread) - (Libor + Repo spread)

Consider the following example:

• One AAA rated firm funds at L-10bp;
• One single-A rated firm funds at L+10bp.

CDS spread for the AAA rated firm =  ASW Spread + 10bp
CDS spread for the A rated firm =  ASW Spread - 10bp

If we assume funding cost for all other market participant is in between of funding cost of  these two market participants than these two spreads will be the boundary spreads of the CDS. Arbitrage trading will keep CDS spreads in this range.

The AAA firm buys the bond and buys protection. It borrows at Libor-10bp, buys the bond yielding L+ASWbp, and pays ASWbp for protection, thereby locking in a 10bp profit with zero net exposure to the bond. . This arbitrage comes from its sub-Libor funding cost advantage.
The single-A firm sells CDS protection outright. It earns ASW bp, whereas if it borrows to buy the bond, it earns only ASW-10bp. It avoids the Libor-plus funding cost disadvantage, and effectively achieves funding at Libor through the CDS position.

So the AAA firm buys protection from the single-A one. The supply-demand equilibrium between them determines the actual level of CDS premium. In any case, these arbitrage activities keep the CDS premium within a certain range of cash spread,linking the two markets.

As we can see, these arbitrage activities are driven by differences in funding costs, where higher-rated entities are protection buyers and lower-rated entities protection sellers.Nevertheless, we cannot generalise that all protection buyers in the CDS market have higher credit quality than protection sellers, because people participate in the market for reasons other than funding cost arbitrage. For example, banks, no matter whether rated AAA or A, can be net buyers of protection for purposes of managing their regulatory or
economic capital.

Discounted bonds - 
The above relationship breaks with discounted bonds ( bonds getting traded at below par value). For discounted bonds, protection seller will have far more risk than bond buyer because loss will be notional - recovery value while for bond buyer loss will be market value (discounted value) - recovery value in case of default. Points up front method gets used in these cases where protection buyer will pay one time up front payment apart from regular premium.