Often people think the world of finance is very complex but in essence it is not that complex. Take for example sovereign credit default swaps:
A protection seller sells credit protection on a 5 year credit default swap on Greek debt with a face value of €10 million for 400 basis points (i.e.4%). This means the protection buyer will pay an annual premium of €400,000 (split into 4 quarterly
payments per annum of €100,000 per quarter) for insurance against a credit
event (eg. A Greek default) on the debt.
Scenario 1 There is no credit event on the Greek debt
In this case the protection buyer pays €400,000 a year for 5 years which means the protection buyer has paid €2 million in total and gets nothing in return. The protection seller will have a profit of €2 million (plus any interest earnt on the premiums).
Scenario 2: The is a Greek Default on its debt after year 1
If Greece defaults after 1 year then the protection buyer will have made 4 quarterly payments of €100,000 each making at total of €400,000. These payments will now cease, the protection buyer will now need to hand over Greek bonds with a face value of €10 million to the protection seller. Let’s assume that these are now trading at a discount to their face value (because of the default) at €3 million in the market. Once in receipt of the bonds the protection seller will
then make a payment of €10 million to the protection buyer.
The net result is that the protection buyer has handed over premiums of €400,000 and bonds to the value of €3 million and so is better off than if they had not bought the CDS by €6.6 million.
By contrast, the protection seller has received premiums of €400,000 and holds the Greek debt at the market place valuation of €3 million and so is €6.6 million worse off than if they had not sold the CDS.
What happens if the probability of a Greek default rises?
If a credit event has not occurred but the probability of a Greek default rises then protection sellers will want to charge a higher premium on any new CDS contracts that they write. This means that the CDS spreads they charge will rise. For example, they may increase the premium from 400 basis points (i.e. 4%) to 1,000 basis points (i.e. 10%) if this happens the fee rises from €400,000 per year (i.e. €100,000 per quarter) to €1,000,000 per year (i.e. €250,000 per quarter).
Below are some selected Sovereign CDS contracts on Sovereign bonds measured in basis points through the duration of the financial crisis.
A protection seller sells credit protection on a 5 year credit default swap on Greek debt with a face value of €10 million for 400 basis points (i.e.4%). This means the protection buyer will pay an annual premium of €400,000 (split into 4 quarterly
payments per annum of €100,000 per quarter) for insurance against a credit
event (eg. A Greek default) on the debt.
Scenario 1 There is no credit event on the Greek debt
In this case the protection buyer pays €400,000 a year for 5 years which means the protection buyer has paid €2 million in total and gets nothing in return. The protection seller will have a profit of €2 million (plus any interest earnt on the premiums).
Scenario 2: The is a Greek Default on its debt after year 1
If Greece defaults after 1 year then the protection buyer will have made 4 quarterly payments of €100,000 each making at total of €400,000. These payments will now cease, the protection buyer will now need to hand over Greek bonds with a face value of €10 million to the protection seller. Let’s assume that these are now trading at a discount to their face value (because of the default) at €3 million in the market. Once in receipt of the bonds the protection seller will
then make a payment of €10 million to the protection buyer.
The net result is that the protection buyer has handed over premiums of €400,000 and bonds to the value of €3 million and so is better off than if they had not bought the CDS by €6.6 million.
By contrast, the protection seller has received premiums of €400,000 and holds the Greek debt at the market place valuation of €3 million and so is €6.6 million worse off than if they had not sold the CDS.
What happens if the probability of a Greek default rises?
If a credit event has not occurred but the probability of a Greek default rises then protection sellers will want to charge a higher premium on any new CDS contracts that they write. This means that the CDS spreads they charge will rise. For example, they may increase the premium from 400 basis points (i.e. 4%) to 1,000 basis points (i.e. 10%) if this happens the fee rises from €400,000 per year (i.e. €100,000 per quarter) to €1,000,000 per year (i.e. €250,000 per quarter).
Below are some selected Sovereign CDS contracts on Sovereign bonds measured in basis points through the duration of the financial crisis.
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