Mini Chapter Five
Zero Recovery CDS vs Standard CDS
Standard market convention is for the protection seller to pay par minus recovery value to the buyer in the event of default. Because the exact recovery rates are unknown – market-makers have their own assumptions – till the event of default a standard contract is also known as Floating recovery CDS. As a variation to the floating recovery contract, we also observe trades wherein the protection seller wishes to have a fixed recovery value built into the price (typically RV = 0) and the dealer/buyer then builds that assumption to arrive at the appropriate CDS level. For instance if a standard recovery for a sovereign bond SSR is implied at 40%, then a zero recovery CDS on the same sovereign risk (i.e. same probability of default) would trade at
Recovery swaps
The recovery Rate on default also has a market in the form of recovery swaps that typically start trading close to the event of default. These are obviously less liquid but at least offer a mechanism to calibrate the credit portfolio pricing/valuation models.
FX risk in a CDS on cross correlation
- Another interesting nuance of the CDS market comes from the different currency notional of the reference entity obligation and that of the CDS contract that offers protection on it. Prima facie if we were to think of buying protection on a local currency INR obligation (INR notional exposure) and use a USD denominated CDS to buy protection on it we would be exposed to currency fluctuations wherein the amount of protection may not equal the underlying exposure at default. Please note however there is no change to the assumptions around probability of default and recovery value even while switching into a different currency for the CDS.
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- Going a step further to assess the degree of correlation between the currency of the reference entity/issuer and its obligation please consider – Premium for a USD denominated CDS to hedge against default risk of an INR denominated SBI bond/loan should account for the movement in USDINR FX at the time of default. In other words, a USD 100 mio equivalent INR obligation for SBI would be worth less in dollar terms at the time of default assuming a sharp INR FX depreciation along with SBI’s default. A 20% expected INR depreciation for instance at the time of default would only need USD 80 mio worth of protection which would be 20% cheaper to buy versus the USD 100 mio notional on the reference obligation at the beginning. Hence, the CDS price on INR notional of SBI’s obligations would be 20% cheaper than the corresponding USD CDS.
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- FX correlation risks on the same underlying credit are also quite common. If a dealer is long a EUR denominated CDS of a European Quasi-Sovereign but short its USD denominated CDS, the risk exposure, while mitigated on the underlying credit, still appears as correlation of the underlying with the respective currencies. If the correlation of the Quasi-Sovereign’s credit quality is high/positive with EUR FX movements, it would be natural for the market to price the EUR denominated CDS cheaper than the one in USD as in the event of default the recovery value in EUR would be much lesser than that in USD. CDSs denominated in a highly positively correlated currency denote wrong way risks as recovery value is vulnerable to FX gap risk in the event of default.
- Credit risk in a CDS – a protection buyer in a CDS contract has taken the view to hedge the credit risk of the reference entity/obligation but in doing so ends up taking credit risk on the seller to the extent of settling the par minus recovery value contingent on the default. On the other hand the seller also runs credit risk on the buyer to the extent of the periodic coupons, but by way of magnitude this is a much smaller risk than what the buyer runs on the seller for the full contingent settlement amount. Going a step further, credit risk for the buyer can get accentuated in case of a correlation between the credit risk of the seller and the reference entity/obligation. Buying USD denominated credit protection on the Republic of Korea from a Korean security company would now bring in correlation or wrong-way risk owing to the credit correlation between the seller and reference entity (credit gap risk). This should be priced by the buyer of the CDS akin to how a CVA charge is incorporated in bilateral non-CSA swaps.
