Credit Default Swap: Basics

A CDS is a contract that provides protection against the risk of a credit event by a particular company or country. The company is known as the reference entity and a default by the company is known as a credit event. The buyer of the insurance obtains the right to sell a particular bond issued by the company for its par value when a credit event occurs. The bond is known as the reference obligation and the total par value of the bond that can be sold is known as the swap's notional principal. The buyer of protection makes periodic payments to the protection seller until the occurrence of a credit
event or the maturity date of the contract, whichever is first. If a credit event occurs the buyer is compensated for the loss (possibly hypothetically) incurred as a result of the credit event.
A credit event usually requires a nal accrual payment by the buyer. The swap is then settled by either physical delivery or in cash. If the terms of the swap require physical delivery, the swap buyer delivers the bonds to the seller in exchange for their par value.
When there is cash settlement, the calculation agent polls dealers to determine the midmarket price, Q, of the reference obligation some specified number of days after the credit event. The cash settlement is then $(100 − Q)% of the notional principal.

The valuation of a credit default swap requires estimates of the risk-neutral probability that the reference entity will default at di erent future times. The prices of bonds issued by the reference entity provide the main source of data for the estimation. If we assume that the only reason a corporate bond sells for less than a similar Treasury bond is the possibility of default, it follows that:
Value of Treasury Bond - Value of Corporate Bond = Present Value of Cost of Defaults

By using this relationship to calculate the present value of the cost of defaults on a range of different bonds issued by the reference entity, and making an assumption about recovery rates, we can estimate the probability of the corporation defaulting at di erent future times. If the reference entity has issued relatively few actively traded bonds, we can use bonds issued by another corporation that is considered to have the same risk of default as the reference entity. This is likely to be a corporation whose bonds have the same credit rating as those of the reference entity and ideally a corporation in the same industry as the reference entity.
We start with a simple example. Suppose that a ve-year zero-coupon Treasury bond with a face value of 100 yields 5% and a similar ve-year zero-coupon bond issued by a corporation yields 5.5%. Both rates are expressed with continuous compounding. The value of the Treasury bond is
100 x e^(−0.05×5) = 77.8801
and the value of the corporate bond is 100 x e^(−0.055×5) = 75.9572. The present value of the cost of defaults is, therefore
77.8801 − 75.9572 = 1.9229
Define the risk-neutral probability of default during the five-year life of the bond as p. If we make the simplifying assumption that there are no recoveries in the event of a default, the impact of a default is to create a loss of 100 at the end of the five years. The expected loss from defaults in a risk-neutral world is, therefore, 100p and the present value of the expected loss is
100 x p x e^(−0.05×5)
It follows that: 100 x p x e^(−0.05×5) = 1.9229
so that p = 0.0247 or 2.47%.
There are two reasons why the calculations for extracting default probabilities from bond prices are, in practice, usually more complicated than this. First, the recovery rate is usually non-zero. Second, most corporate bonds are not zero-coupon bonds. When the recovery rate is non-zero, it is necessary to make an assumption about the claim made by bondholders in the event of default.

UCITS : Undertakings for Collective investment In Transferable Securities

Off late mutual funds are also showing the aggresion which was once idiosyncracy of hedge funds. Now they are also chasing alpha and craving for absolute returns. Thanks to UCITS, restirctions made easy and derivatives and OTC available as investment avenues.

Background
In simple terms, a UCITS is a mutual fund based in the European Union. UCITS stands for “Undertakings for Collective Investment in Transferable Securities” and UCITS funds can be sold to any investor within the European Union under a harmonised regulatory regime.
They have a strong brand identity across Europe, Asia and South America and are distributed for sale in over fifty countries as they have transparent, tried and tested regulation. The original Directive introducing the concept of a standard fund structure, “UCITS I”1, was adopted in 1985. However, due to differing cross border marketing restrictions in member states and the restricted range of asset classes permitted, the original Directive prevented UCITS from benefiting from the increasing range of investments that were available in the market. A second draft directive – UCITS II – was developed to rectify these issues, however extended political arguing between EU countries caused it to be abandoned.

UCITS III – development for change
It was not until 2003 that UCITS I was amended by a new Directive, UCITS III, which was itself made up of two directives: the Product Directive2 and the Management Directive3. The Product Directive expanded the type and range of investments that a UCITS could hold; The Management Directive sought to give a European passport to management companies of a UCITS fund to enable them to operate throughout the EU as well as tightening up risk management frameworks and increasing managers’ capitalisation requirements. The combined Directive was intended to widen consumer choice and consumer protection. It is this combined UCITS III Directive that fund managers now refer to when they talk about “UCITS-III-compliant” or “Newcits” funds. In general, they mean the fund is taking advantage of the wider investment powers. But there is a good deal more going on behind the scenes. One of the key benefits of the UCITS III Product Directive was the broadening of the investment powers available to mutual funds. This included derivatives for specific investment purposes and it has taken some years for the industry to realise that this enhanced breadth presents managers with the ability to offer a much fuller range of investment products than had previously been the case.
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The Management Directive developed the existing concept of the “product passport”, on which BlackRock’s European Retail distribution model is based. Under the passport, a UCITS fund in one member state can be freely marketed to investors in another EU4 country, subject to a processing period of up to two months by the regulator in the other country.
The Management Directive also introduced new prospectus requirements as well as demanding that all UCITS funds use a “Simplified Prospectus” as a marketing document throughout the EEA. Permissions to allow managers to operate funds domiciled in other countries (the “management passport”) was not however a complete success and the new UCITS IV Directive, which will come into force in 2011, in part aims to rectify this.
BlackRock in the UK was one of the first firms to see the possibilities for UCITS III, with the launch in 2005 of UK Absolute Alpha. Since then, we have launched other funds and now offer a wide range of UCITS-III-compliant funds as well as seven “Newcits” funds to UK and European investors, investing in equity, fixed income and foreign exchange.
Regulatory change is constant, now more so than ever, but since UCITS III, further EU Directives, rules and guidance have been published, building on its base. This includes the Eligible Assets Directive5 which formally widened and clarified the scope of UCITS’ investments, the European Commission Recommendation for the use of financial derivative instruments for UCITS6 which introduced additional aspects and demands in risk monitoring and additional guidance by CESR7 on an assortment of matters.


Main Features of a UCITS
A UCITS can only invest in eligible assets. The original UCITS directive was restrictive in scope and effectively allowed only equity and bond funds.
UCITS III expanded the range of available investments to include derivatives for investment purposes, other UCITS and cash. This dramatically increased investor choice, allowing for cash funds, funds of fund, mixed asset funds.

UCITS must operate on a principle of risk spreading, which means that restrictions apply which limit the spread of investments, leverage and exposure. UCITS III, however, re-defined how derivative exposure can be measured.
A UCITS must be open-ended i.e. shares or units in the fund may be redeemed on demand by investors.
A UCITS must be liquid, that is, its underlying investments must be liquid enough to support redemptions in the fund on at least a fortnightly basis. In practice of course, the vast majority of UCITS funds are daily dealing.
Assets must be entrusted to an independent custodian or depositary and held in a ring-fenced account on behalf of investors.

The development of investment powers
Eligible Assets
As part of UCITS III then, the Product Directive expanded the type of available investments to allow a UCITS to invest in derivatives not only for efficient portfolio management “EPM” or hedging purposes but for investment purposes as well.
This has allowed a number of hedge fund strategies to be accommodated within the UCITS format such as equity long/short, relative value, etc. Some strategies, however, will not easily fit within a UCITS framework because the underlying asset class is not permissible (e.g. individual commodities or bank loans) or because of the lack of liquidity (e.g. distressed debt). The eligible assets that a UCITS can invest in include:

Transferable securities – effectively, publicly traded equities or bonds, listed on mainstream stock exchanges. Broadly, this was the range of assets allowed under UCITS I. Under UCITS III, choice has become wider after 2003.
Deposits and Money Market instruments (MMIs) – Cash deposits with “credit institutions” (i.e. banks) can now be held as investment assets, together with MMIs. These might include treasury and local authority bills, certificates of deposit or commercial paper. Thus pure cash funds can now be UCITS.

Other mutual funds – UCITS have always been able to invest in other funds, although this was tightly restricted. UCITS III relaxed this restriction, with further ability to invest in other open-ended mutual funds where those are other UCITS or non-UCITS funds with UCITS-like traits. This has allowed the development of UCITS funds of funds.

Financial Derivative Instruments – under UCITS I, derivatives could only be used for hedging and EPM (i.e. to reduce risk or cost, or to replicate a position that could otherwise be achieved through investing in the underlying asset). With the advent of UCITS III, UCITS are able to use derivatives for investment purposes, using exchangetraded or over-the-counter (“OTC”) instruments, with some limitations. The underlying of a derivative must be:
• an eligible asset of the type mentioned above
• interest rates
• foreign exchange rates and currencies
• financial indices (e.g. S&P 500).
Physical short selling is not permitted. However, the same economic effect can be achieved and is allowed through the use of derivatives such as Contracts for Difference (“CFDs”). Firms must have systems and controls in place that can measure the derivative risk and provide an appropriate level of cover, which can mean that on the opposite side of the exposure there must be cash, a similar asset or balancing derivative giving an opposite exposure to a similar underlying asset to cover the original derivative exposure. It can also mean that some UCITS III funds may have high levels of gross exposure.

Ineligible assets – certain assets remains out of scope:
Real estate
Bank loans
Physical metals such as gold (although certain securities based on metals are permitted)
Commodities (although derivatives on financial indices such as commodity indices are eligible)

Risk spreading and concentration rules
A UCITS must be properly diversified. There are a number of different limits, all of them in place since UCITS I, but the best known is the 5/10/40 Rule. This states that a UCITS cannot invest more than 5% of its assets in securities issued by a single issuer. However, this limit can be increased up to 10% provided that where the 5% limit is exceeded, the exposure to these issuers, when added together, does not exceed 40% of the fund’s assets. There are also rules round the proportion of a company that a UCITS may hold in that it might gain significant influence over its management. Rules exist too regarding the amount of a company’s debt or non-voting shares that can be held.