CH Capital CDS Market

7/31/2019 CH Capital CDS Market

1/23

CHCapitalPartnersLLC

CreditDefaultSwap

Howitworks

By

SokH.CordellSr.ManagingDirector

Knowwhoyouareworkingwith

ContinuallyStrivingtoEducatethePublicTocreatejobsforourFellowAmericans


2/23

CreditDefaultSwaps

ACredit

Default

Swap

(CDS)

is

acontract

in

which

the

writer

offers

the

buyer

protectionagainstacrediteventinareferencenameforaspecifiedperiodof

timeinreturnforapremiumpayment.

TypicalCDScashflows

Thecontract

pays

par

in

return

for

100

nominal

of

debt

if

the

reference

name

suffersacrediteventbeforethematurityofthedeal.

Thebuyerpaysapremiumquarterlyinarrears.


3/23

CDSStructure

Protection

BuyerProtection

Seller

Quarterlypremium

inarrears

Protection

Buyer

Protection

Seller

Defaulteddebtof

referencename

Parless

fractionof

premium

Predefault

Postdefault


4/23

StochasticLoanPricingModelFinancialEngineering

-$17.28 $15.69

5.0%4.2%

90.0%90.0%

5.0%5.8%

0.000

0.005

0.010

0.015

0.020

0.025

0.030

0.035

0.040

0.045

-$

30

-$

25

-$

20

-$

15

-$

10

-$

5

$

0

$

5

$

10

$

15

$

20

$

25

Loan $ AmountComparison with Normal(0,10)

LoanAmount Normal(0,10) Log.(Normal(0,10))

DelX DelY

17.28253 0.045

15.69024 0.045

23.64127 0.045

0.796149 0.045

20.34512 0.045

X1 Y1

25.18757 0.004103

22.75059 0.004103

20.31361 0.008207

17.87663 0.008207

15.43965 0.016414

13.00266 0.016414

10.56568 0.028724

8.128702 0.028724

5.69172 0.036931

3.254739 0.041034

0.817758 0.036931

1.619223 0.041034

4.056204 0.032828

6.493185 0.028724

8.930167 0.024621

11.36715 0.020517

13.80413 0.01231

16.24111 0.008207

18.67809 0.004103

21.11507 0.008207

23.55205 0

X2 Y2

30 0.000443

29.88978 0.000458

29.77956 0.000473

29.66934 0.000489

29.55912 0.000505

29.4489 0.000522

29.33868 0.000539

29.22846 0.000557

29.11824 0.000575

29.00802 0.000594

28.8978 0.000613

28.78758 0.000633

28.67735 0.000653

28.56713 0.000674

28.45691 0.000696

28.34669 0.000718

28.23647 0.000741

28.12625 0.000764

28.01603 0.000788

27.90581 0.000813

27.79559 0.000838


5/23

StochasticLoanPricingModelFinancialEngineering

-$17.28 $15.94

5.0%4.2%

90.0%90.2%

5.0%5.6%

0.000

0.005

0.010

0.015

0.020

0.025

0.030

0.035

0.040

0.045

-$

30

-$

20

-$

10

$

0

$

10

$

20

$

30

$

40

Net IncomeComparison with Normal(0,10)

NetIncome Normal(0,10)

Del X Del Y

-17.2795 0.045

15.936 0.045

-23.6397 0.045

-0.67174 0.045

27.968 0.045

X1 Y1

29.75648 0.003142

26.57389 0

23.3913 0.003142

20.20872 0.009426

17.02613 0.009426

13.84355 0.018853

10.66096 0.028279

7.478374 0.034563

4.295788 0.034563

1.113201 0.040847

2.069385 0.037705

5.251971 0.031421

8.434557 0.021995

11.61714 0.018853

14.79973 0.009426

17.98232 0.006284

21.1649 0.003142

24.34749 027.53007 0

30.71266 0.003142

33.89525 0

X2 Y2

30 0.000443

29.85972 0.000462

29.71944 0.000482

29.57916 0.000502

29.43888 0.000524

29.2986 0.000546

29.15832 0.000568

29.01804 0.000592

28.87776 0.000617

28.73747 0.000642

28.59719 0.000668

28.45691 0.000696

28.31663 0.000724

28.17635 0.000753

28.03607 0.000784

27.89579 0.000815

27.75551 0.000847

27.61523 0.000881

27.47495 0.000916

27.33467 0.000952

27.19439 0.000989


6/23

CreditDefaultSwaps

LenderPurchasesCDSfromaCounter

Partyforcost

Premiumsfromthelenderispaidaspart

ofthecostofInsurance

FinancialModelsarecreatedto

determinethecostandpriceofthe

insurance

TheCDSsaretradedonadailywith

Bloombergorotheritemstopriceonthe

dailytrade

ThesearetheinstrumentsthatbasicallybroughttheUSeconomy

down

LikeaStock,theseinstrumentsarepriced

everyminute

TheproblemsareveryfewpeoplewithMathand

EngineeringDegrees

understandthecomplexityoftheseinstruments

Inanefficientmarketwithhighlypaidcompetent

professionals,it humanscannotmakedecisionsontheseengineeringmodels

quickenough

Thatisthereasonforthedisclosurescanbeaslongas

2,000pageswithlegaljargonthatisoftenhardto

understand

CDSisverycomplexwith

FinancialEngineering

Models


7/23

CashFlowfromCDS

Likeindividuals

pay

for

Mortgage

Insurance

or

Auto

Insurance,

the

CDSs

have

premiums

in

which

theinsuredisbuyingonamonthlyorquarterlypayments.

ThesepaymentsissubtractedfromtheriskandcalculatedwiththefutureprofitthroughNPV

Modelswhichhelpthetradersunderstandwhatheorsheisbettingontheotherside.

CDSsaresocomplex,sometimesthetradersdonotevenunderstandwhichsideheorsheis

betting

Theseinstrumentscreatecashflowfortheinsurerandtheinsuredpaysthatcashflow.

Whatstartedouttobeasimplemarket,hasturnedintoacalculatedbetonWallStreet.

Itisnolongerbenefittingtheeconomy,butactuallybenefittingfewfirmswhocanhirethebest

peoplewhofullyunderstandtheCreditDefaultSwapMarkets,theseEngineerscreatemodelsare

socomplicated,

depending

on

who

created

the

model,

most

in

the

market

place

and

risk

managers

cannotfullycomprehendthesophisticatedriskitimposestotheeconomy.

CreditDefault

Swaps

PremiumsPaidMonthlyInsuredCreatesSecuritiesfortheseinstruments


8/23

Time Hazard Default Survival

(years) Rate Probability Probability

0 1

1 0.02 0.02 0.98

2 0.02 0.0196 0.9604

3 0.02 0.019208 0.941192

4 0.02 0.01882384 0.92236816

5 0.02 0.018447363 0.903920797

Nowweconsidera5YearCDSonthisReferenceEntity.

AdditionalAssumptions:

RecoveryRate 0.4

SwapPayments

LIBOR 0.05

NotionalPrincipal 1

CDSSpread 0.012424885

1

0.012176387

0.951229425

0.011582538

0

0.2

0.4

0.6

0.8

1

1.2

0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

PremiumsReceived

PremiumPricing

CDSPremiumPricing

Year1

Year2

Year3

Year4

Year5

PremiumPricingModelforCDS


9/23

CDSExample

ProtectionBuyer

Protection

Seller

314.486bps

quarterlyinarrears

Protection

Buyer

Protection

Seller

$1,000,000

plusfractionof

premium

Predefault

Postdefault

$1,000,000Par

GMAC


10/23

ParAssetSwapExample

InterestRate

SwapDesk

Trading

DeskInvestor

Floating Floatingpayments

+paratmaturity

ParFixed

Credit

Market

CashBondDirtyPriceFixedCoupon

CreditBond


11/23

CDS AssetSwapHedge

InterestRate

SwapDeskTrading

Desk

Investor/

Protection

Buyer

Floating Floatingpayments

+paratmaturity

ParFixed

Credit

Market

CashBondDirtyPriceFixedCoupon

CreditBond

Protection

Seller

Quarterlypremium

inarrearsand

defaulted

debt

upon

default

Parless

fractionof

premiumupon

default


12/23

AssetsSwap

SampleFacilityInformation

BorrowerHospitalityofWashington

Lenders:CMBSConduitLender

Amount:$11,000,00010yearNonRecourse

Purpose:ConstructiontoPermanentLoan

Lender'sROAGuideline:1.15%

FacilityInformationEnterUnsecured LineofCredit(AssumedToBeFullyUtilized) 11,000,000

Enter12MonthAverageBalances(AssumeBalancesNotFree) 657,000

EnterBaseRate(PrimeorLIBOR) 10.5%

EnterSpreadOverBase 1.75%

Enter %FacilityFees(NotConnectedToBalances!) 2.00%

EnterFundingCostsofWACC 2.65%

EnterServicing:Enter%orCompleteScheduleTwo 1.70%

EnterLoan

Loss

Expense

(Applied

To

Income

Statement) 1.50%

Enter%EquityReserveRequirement(FunctionofUnexpectedRisk) 25.00%

EnterTaxes 35%

DepositInformation12monthaveragebalances 657,000

EnterActivityCostsasaPercentofBalances 4.09%

EnterBalanceRequirement 8.75%

NetBorrowedFunds 10,343,000

InterestRate:Prime+1.5% 12.21%

FeesinlieuofBalances 7,673

ReturnonAssetsCalculation

LoanAmount 11,000,000

NetIncome 601,288

ReturnonAssets 5.466%

ReturnonRiskAdjustedCapitalCalculation

%EquityReserve Requirement(FunctionofUnexpectedRisk) 25.00%

LoanAmount 11,000,000

$AmtEquityReserve Allocation(FunctionofUnexpectedRisk) 2,750,000

NetIncome 601,288

RAROC 21.87%

Summary:BaseCase

BorrowerPicnicFurnitureManufacturingCo

Lenders:SecondCityBank

LoanRevenue

1,570,55

9

Facility

11,000,0

00

Net

Income 601,288

ROA 5.466%

FacilityROAHurtleRate 1.15%

FacilityInternalRateofReturn(SeeBradyWorksheet)

OptionPricingGeneratedHurtleRate(OptionPr

Worksheet)

RAROC 21.87%


13/23

AssetSwapCalculator

Base Value:0.0139484609812889 Input Changes

Precedent Cell

Output

Downsi

de

Output

Upside

Effectiv

e

Range

Input

Downsi

de

Input

Upside

Base

Case

Value

Base Rate (Prime or

LIBOR) 0.72% 2.07% 1.36% 9.4% 11.5% 10.5%

Funding Costs 1.94% 0.85% 1.10% 7.59% 9.27% 8.43%

Servicing 1.57% 1.22% 0.35% 2.43% 2.97% 2.70%

% Facility Fees 1.26% 1.52% 0.26% 1.80% 2.20% 2.00%Spread Over Base 1.28% 1.51% 0.23% 1.58% 1.93% 1.75%

Loan Loss Expense 1.49% 1.30% 0.20% 1.35% 1.65% 1.50%

Enter Taxes 1.47% 1.32% 0.15% 32% 39% 35%

Balance

Requirement 1.34% 1.44% 0.10% 9.00%11.00% 10.00%

Facility Amount 1.34% 1.44% 0.10%

900,00

0

1,100,0

00

1,000,0

00

Cost of Funds 1.34% 1.44% 0.10% 7.43% 9.08% 8.25%

Unsecured Line of

Credit 1.44% 1.36% 0.07%

900,00

0

1,100,0

00

1,000,0

00

Annual Activity

Costs 1.41% 1.38% 0.03% (1,800) (2,200) (2,000)

Reserve % Facility 1.40% 1.39% 0.01% 6.30% 7.70% 7.00%

Allocated Variable 1.39% 1.39% 0.00% 0 0 0

Direct fixed 1.39% 1.39% 0.00% 0 0 0

Cost of Funds 1.39% 1.39% 0.00% 7.43% 9.08% 8.25%

Direct Variable 1.39% 1.39% 0.00% 0 0 0

Balance

Requirement 1.39% 1.39% 0.00% 9.00%11.00% 10.00%

Loan Loss Reserve

% Facility 1.39% 1.39% 0.00% 6.30% 7.70% 7.00%

Allocated fixed 1.39% 1.39% 0.00% 0 0 0

LIBOR (Prime) Rate 1.39% 1.39% 0.00% 9.45%11.55% 10.50%

Facility Amount 1.39% 1.39% 0.00%

900,00

0

1,100,0

00

1,000,0

00

1.39%

1.39%

0.00%

9.45%

11.55%

10.50%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

0.00% 10.00%20.00%30.00%40.00%50.00%

OutputDownside

OutputUpside

EffectiveRange

InputDownside

InputUpside

BaseCaseValue

CDSPriceModel

LIBOR(Prime)Rate

Allocatedfixed

BalanceRequirement

CostofFunds

Reserve%Facility

CostofFunds

FacilityAmount

BalanceRequirement

EnterTaxes

SpreadOverBase

%FacilityFees


14/23

SwapModelPricing

Time Recovery Expected Discount PVof

(years) Rate Payoff Factor* ExpectedPayoff

0.5 0.4 0.012 0.975309912 0.011703719

1.5 0.4 0.01176 0.927743486 0.010910263

2.5 0.4 0.0115248 0.882496903 0.0101706

3.5 0.4 0.011294304 0.839457021 0.009481083

4.5 0.4 0.011068418 0.798516219 0.008838311

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

1 2 3 4

Premium

Pay

Off

Years

CDSPremiumPayoff

4.5

3.5

2.5

1.5

0.5


15/23

CDS AssetSwapHedgeExample

InterestRate

SwapDesk

Market

Makers

Protection

Buyer

Credit

Market

Protection

Seller

$10,000,000Par

MortgagePool55/8s

of5/15/2020

Floating3M

LIBOR+273.7bps

$10,000,000

initially

Fixed

5.45232%

semi

annual

Floating3M

LIBOR+256.8bps

314.486bps

quarterlyinarrears

$10,000,000

lesspartial

premiumon

defaultevent

$10,000,000

parof

Mortgage

Tranchedebt

ondefault

event

$9,300,000+$42,187.50=$9,342,187.50


16/23

InitialCashflows

InterestRate

SwapDeskMarket

Makers

Protection

Buyer

Credit

Market

Protection

Seller

$10,000,000Par

MortgagePool55/8s

of5/15/2020

$9,300,000+$42,187.50=$9,342,187.50

$10,000,000

initially

$719,881


17/23

TypicalPeriodicCashflows

InterestRate

SwapDesk

Market

Makers

Investor/

Protection

Buyer

Market

Protection

Seller

$281,250

semiannually

LIBOR+$68,425

quarterly

(approx.

$204,200)

$272,616semi

annually

LIBOR+$64,200

quarterly

(approx.

$200,000)

$79,495quarterly


18/23

CashflowsonDefault

InterestRate

SwapDesk

Market

Makers

Protection

Buyer

Credit

Market

Protection

Seller

$10,000,000Par

defaulted

MortgagePool 55/8s

of5/15/2009

$10,000,000

lesspartial

premium

UnwindIRswapUnwindIRswap

$10,000,000Par

defaulted

MortgagePool55/8s

of5/15/2009orsimilar


19/23

IstheProtectionBuyerHedged?

Upondefault,theprotectionbuyerreceives$10mfromtheprotectionseller

and(assuming40%recovery)deliversdefaulteddebtworth$4m.Atthe

inceptionof

the

contract,

the

Mortgage

Pool

note

was

only

worth

$9.3m.

So

thebuyerreceivesanetof$6mfromtheCDS,hasreallylostonly9.34=$5.3m.

SothebuyerhastoomuchCDS.Thecorrecthedgeratioisgivenby

Inthiscasetheprotectionbuyershouldbuy$10mx(.93.4)/(1.4)=$8.9m

notionalCDStobehedged.

( )

(1 )

bond price R

CDS notional bond notional R


20/23

CDSBasis

Anumber

of

factors

observed

in

the

market

serve

to

make

the

price

of

credit

risk

that

hasbeenestablishedsyntheticallyusingcreditdefaultswapstodifferfromitspriceas

tradedinthecashmarketusingassetswaps.

Identifyingsuchdifferencesgivesrisetoarbitrageopportunitiesthatmaybeexploited

bybasistradinginthecashandderivativemarkets.Thisinknownastradingthecredit

defaultbasis

and

involves

either

buying

the

cash

bond

and

buying

aCDS

on

this

bond,

orsellingthecashbondandsellingaCDSonthebond.

Thedifferencebetweenthesyntheticcreditriskpremiumandthecashmarket

premiumisknownasthebasis.

CDSPremium

Z

Spread

=basis.


21/23

CDSBasis

Basis=314.486291.9=22.586

InterestRate

SwapDeskMarket

Makers

Protection

Buyer

Credit

Market

Protection

Seller

$930,000+$4,218.75=$934,218.75

Floating3M

LIBOR+273.7bps

$1,000,000Fixed

5.45232%

semiannual

Floating3M

LIBOR+256.8bps

314.486bps

quarterlyin

arrears

$10,000,000Par

GMAC55/8s

of5/15/2009

ZSpread=291.9


22/23

CDSBasis

Thebasis

is

usually

positive,

occasionally

negative,

and

arises

from

a

combinationofseveralfactors,including

Bondidentity:Thebondholderisawareoftheexactissuethattheyareholdingin

theeventofdefault;however,defaultswapsellersmayreceivepotentiallyany

bond

from

a

basket

of

deliverable

instruments

that

rank

paripassu with

the

cash

asset.Thisisthedeliveryoptionheldbytheprotectionbuyer.

Dependingontheprecisereferencecredit,theCDSmaybemoreliquidthanthe

cashbond,resultinginalowerCDSprice,orlessliquidthanthebond,resultingina

higherprice.


23/23

Disclosure

Theseslides

are

for

educational

purpose

only,

CH

Capital

Partners

LLC

amember

of

CFG

is

not

liable

for

any

information

pertaining

the

subject

matter.

Thesematerialsareforeducationalonly.CHCapitalPartnersLLC isregisteringtobeaRIAfirmtospecializeincreatingSBA FMLPLoanFundsforinvestors,

CHCapitalPartnersLLChasextensivebackgroundinbondfinancingtostructureandcreatingloansandpackagingthroughallpartsoftheprocess.

CH Capital CDS Market

Documents