JP Morgan - Trading Recovery Rates - Digital Default Swaps and Recovery Swaps
JP Morgan - Trading Recovery Rates - Digital Default Swaps and Recovery Swaps
CDS
Rishad Ahluwalia
150 DDS (44-20) 7777-1045
[email protected]
100 J.P. Morgan Securities Ltd.
50
0
Jan-03 Apr-03 Jul-03 Oct-03 Jan-04
Source: JPMorgan
Introduction
With the continued success and still increasing volumes on CDS index
products such as DJ TRAC-X Europe and DJ CDX.NA.IG, it is a natural
extension of the product range from options, tranches, various maturities,
and various formats to also include Digital Default Swaps (DDS) and
Recovery Swaps. DDS is a simplified version of a CDS, resulting in a
shorter settlement process, and serving a number of purposes for both fund
managers, hedge funds, corporates and banks. A Recovery Swap is simply
a CDS and a DDS bundled together allowing investors to isolate views on
recovery rates. As liquidity in these index type products increases, trading
in the underlying single name DDS is likely to pick up as well. In this short
www.morganmarkets.com
Credit Derivatives Strategy
note, we describe the mechanics of DDS and Recovery following a Credit Event to be of equal value as well:
Swaps and highlight their many uses.
$10m x (1-Rimplied) = $5m
How do Digital CDS work?
hence
A Digital CDS, also called a Digital Default Swap (DDS), is a
simplified version of a regular CDS. The only difference Rimplied = 50%
being that a DDS has a predetermined recovery rate (and
hence payout) in case of a Credit Event occurring. The In a similar way, we can deduce some more generic relation-
recovery rate in a DDS can be fixed at any level, whereas ships. Again, consider the following positions:
recovery rates on regular CDS depend on where the deliver-
able obligations trade following a Credit Event. In this c) - Long CDS protection
research note we assume that the DDS is set at 0% recovery - Notional = 1
unless otherwise stated. - Fee leg = SCDS
expected payoffs for the CDS and the DDS). Intuitively this - Fee leg = S x S / S = S
DDS CDS DDS CDS
makes sense as the expected loss on a DDS is relatively - Payout following Credit Event = S / S CDS DDS
2 19 May 2004
Credit Derivatives Strategy
Trading Recovery Rates - Digital Default Swaps and Recovery Swaps
instrument - depending on investor demand. We will look at each one of these features in turn.
In case there is a Credit Event during the life of the Recovery DDS-based Indices Trade Wider
Swap, the investor short recovery rates will make money on
the trade if he is able to buy defaulted debt at a lower price As mentioned earlier, a DDS will always trade at a higher
spread than a plain vanilla CDS assuming it has a fixed
than the recovery rate implied by the market at the time of
recovery rate of zero percent. In Chart 1, we have simulated
trading. If, for example, the market implied recovery rate on
the spread history on CDS and DDS based credit derivative
the trade date is 50%, the company in question experiences a indices by making an assumption about the implied recovery
Credit Event and the investor buys bonds in the market at rate. We have used the market standard 40% rate for
40% of par, the investor can deliver these bonds into the simulating the DDS history. This is roughly in line with
contract, receive 50% of notional traded, and net make 10% Moodys estimate of long-term average corporate recovery
times notional on the trade. rates in the US market of 37%.
It is important to note that when we discuss recovery rates From the previous section we know that there is the follow-
in the context of Recovery Swaps, we mean the cheapest ing relationship between CDS and DDS spreads:
deliverable type of debt the investor can source in the
market following the Credit Event. This is distinct from the (3): S = S DDS CDS / (1-Rimplied)
long term recovery rates - the value of debt instruments after
which means that using an implied recovery rate of 40% will
a company has finished its bankruptcy restructuring.
make the DDS credit derivative index trade at a spread
multiple of
Digital CDS and Tradable CDS Indices
S DDS =S CDS / (1-40%) = 1.67S CDS
DDS can of course also be applied to products based on
single name CDS, such as the tradable CDS indices, DJ
Using a constant implied recovery rate (and hence spread
TRAC-X Europe and DJ CDX.NA.IG. There are at least three
multiple) is a crude approximation used in Chart 1 for
main reasons why such products should have investor
illustrative purposes. We expect implied recovery rates to
appeal:
change regularly, depending on investors views on recover-
ies, whereas in our assumed history they are static over time.
1) A DDS index trades at wider spread than a regular CDS
In Table 1 we show the spreads on CDS and DDS based
index
credit derivative indices for various implied recovery rates.
For example, with CDS credit derivative index spreads at
2) DDS indices are easier to settle following a Credit Event
50bp and assuming a 40% implied recovery rate, DDS credit
3) DDS indices allow for capital efficient investments
Table 1: CDS and DDS Credit Derivative Indices for Various Implied
Recovery Rates
Chart 1: CDS Credit Derivative Index vs. DDS Credit Derivative Index
CDS Based Implied DDS Based
Simulated CDS Spread, 40% assumed implied recovery rate, bp
Index Recovery Rate Index
250 50 0 50
50 20 63
200 50 40 83
CDS 50 60 125
150 DDS 50 80 250
Source: JPMorgan
100
Table 2: Taking Views on Recovery Rates, Trade Details
50 Position Deal spread Size Duration
Buy CDS protection 50 10,000,000 4.81
0
Sell DDS protection 100 5,000,000 4.73
Jan-03 Apr-03 Jul-03 Oct-03 Jan-04
Source: JPMorgan Source: JPMorgan
3
Credit Derivatives Strategy
derivative index spreads will be at 83bp. By using a DDS As an illustration of how lengthy this process normally is,
based index investors thus get a pick up in spread for taking the last DJ TRAC-X Europe Series 1 contracts were settled in
the same default risk as in regular CDS based index. In case the middle of March 2004 following the default on Parmalat
any of the names in the index experiences a Credit Event, on 24 December 2003. While the Parmalat settlement is
however, the exposure is higher in DDS due to the fixed zero considered to have taken place relatively smoothly, it thus
percent recovery rate. This pick up in spread should be still took almost three months before all contracts were
particularly attractive for investors searching for yield in the settled.
aftermath of the strong spread compression experienced
from October 2002 to early this year. In particular, investors Taking Views on Recovery Rates - CDS,
who are looking to go long credit and who do not believe
any of the names in, for example, DJ TRAC-X Europe or DJ
DDS and Recovery Swaps
CDX.NA.IG will experience a Credit Event should use DDS. As mentioned earlier the relationship between DDS and CDS
Using a 40% implied recovery rate the DDS spread is 67% spreads provides information about the market implied
higher than the CDS spread, while the extra spread volatility
recovery rate. Assessing the traded data on the two prod-
means that the mark-to-market likewise is 67% higher.
ucts thus makes it easy for investors to take views on
whether they agree with these implied recovery rates.
Settlement on DDS-based Indices
The second key advantage of DDS based indices over plain Imagine for instance that we observe:
vanilla CDS based indices is that the settlement process 1) CDS credit derivative index at 50bp
following Credit Events is much simpler. The reason for this 2) DDS credit derivative index at 100bp
is that no obligations are delivered to the seller of protection,
but only exchange of the notional exposure is taking place. Using (2) we get a market implied recovery rate of:
For example, in case any of the single name CDS comprising
a DDS based index experiences a Credit Event, the buyer of Rimplied = 1- S / S
CDS DDS = 1- 50/100 = 50%
protection will simply receive a payment equal to the
notional exposure to that particular name. The coupon on The investor takes the view that the recovery rate as implied
the DDS index remains unchanged, but is paid on the by the market is relatively too high at 50% - equivalent to the
reduced notional amount. view that DDS spreads are too high. Implementing this view
requires selling protection on the DDS index at 100bp and
Under this simplied structure, settlement on the Digital buying protection on the CDS index at 50bp. For a pure
contracts will take place 5 days after the Notification of the recovery rate trade the notional amounts traded on each side
Credit Event. In contrast, the physical settlement process on should be adjusted to make the trade carry neutral. In the
a regular CDS involves a number of steps (seen from the above example, this means buying 2 units of CDS protection
protection buyers perspective): 1) Notice of physical for every 1 unit of DDS protection sold. The combination of
settlement specifying which obligations to deliver 2) Buying these two trades are economically equivalent to trading a
deliverable obligations, 3) Delivery of deliverable obliga- Recovery Swap. The investor only has exposure to recovery
tions, 4) Receiving the notional amount traded on the CDS. rates and carry on the trade is zero bp. The details of the
trade are outlined in Table 2.
Table 3: Taking Views on Recovery Rates, Scenario Analysis for Table 4: Taking Views on Recovery Rates, Scenario Analysis for
changes in CDS / DDS spreads Credit Events occurring
Implied Number of Realised
CDS CDS P/L DDS DDS P/L Trade P/L Rec Rate Credit Events Recovery Rate CDS P/L DDS P/L Trade P/L
1 50 0 80 47,500 47,500 0.375 1 50% 50,000 - 50,000 -
2 50 0 120 - 47,500 - 47,500 0.583 1 40% 60,000 - 50,000 10,000
3 40 - 47,500 100 0 - 47,500 0.600 3 50% 150,000 - 150,000 -
4 60 47,500 100 0 47,500 0.400 3 40% 180,000 - 150,000 30,000
5 60 47,500 110 - 23,750 23,750 0.455 100 50% 5,000,000 -5,000,000 -
100 40% 6,000,000 -5,000,000 1,000,000
6 60 47,500 120 - 47,500 0 0.500
Source: JPMorgan
Source: JPMorgan
4 19 May 2004
Credit Derivatives Strategy
Trading Recovery Rates - Digital Default Swaps and Recovery Swaps
Let us analyse the P/L impact on the trade given various linear in spreads levels. In other words, when spreads
scenarios for movements in CDS and DDS spreads. increase, the sensitivity of P/L to changes in recovery rates
roughly increases in a linear fashion (although in reality it is
As shown in Table 3, we have in fact managed to isolate the slightly concave).
P/L impact of the trade to changes in implied recovery rates.
Under scenario 1, CDS spreads remain unchanged while DDS and Capital Efficiency
DDS spreads tighten resulting in the implied recovery rate As a note to British-based investors, DDS DJ TRAC-X is a
decreasing to 37.5% and the trade turning profitable. We particularly attractive instrument for financial institutions
observe the opposite pattern under scenario 2: DDS spreads (FI) because of the current capital allocation requirements on
widen out, the implied recovery rate increases and we lose regular CDS. In a regular CDS, FIs are required by the BoE
money. Under scenario 6, both CDS and DDS spreads widen to allocate capital based on how large the potential loss is on
out - note that the implied recovery rate remains unchanged their positions. This means that for an instrument such as
and that the trade P/L is zero. DJ TRAC-X Europe Main, where the typical recovery rate is
around 40%, a FI would still face 100% capital charge as this
It is of course also important to look at what happens in case is the maximum potential loss on the position. The maximum
one or more of the names in the credit derivative index potential loss on a 0% DDS is likewise 100% and the FI
experience a Credit Event and how the P/L is impacted by the could therefore, for the same capital requirement, increase its
realised recovery rate - this is done in Table 4. credit exposure by roughly 67% using DDS. Bear in mind
that the two positions have the same default probability, and
When the realised recovery rate turns out to be exactly equal that the additional exposure entirely is due to the fixed 0%
to the implied recovery rate of 50% the loss on the DDS recovery rate.
position is off-set by the gain on the CDS position resulting
in a net zero P/L. As expected, we make money in the
scenarios when realised recovery rates are lower than the Credit Hedging Applications
implied 50% recovery rate, which was our view at the out- As the pay out on a DDS is independent of the actual
set. In the extreme scenario where all names in the credit recovery rate, DDS do not serve as a good hedge for bonds
derivative index experience a Credit Event our P/L will simply and loans carrying both credit and recovery risk. There are,
be scaled up from the one Credit Event case. however, other types of credit exposure, such as credit
contingent profits and losses, which are independent from
recovery rates. This could, for example, be credit exposure
DDS Valuation with a different level of seniority from the traditional Senior
DDS can easily be valued by using Bloombergs CDSW Unsecured level which CDS are normally traded on. Under
page. Choose a bond in the same currency as the CDS such types of credit exposure the bank would probably be
which you wish to value and type CDSW <GO>. In the field:
Chart 2: P/L Sensitivity to Recovery Rates almost linear in spread
Use Curve Rate type F for false, set the Recovery levels
Rate field below to 0%, type in the notional amount traded, Spreads (x-axis) vs. P/L Impact of a 1% change in recovery rates (y-scale)
the DDS Deal Spread and the maturity of the DDS. The right 16000
hand colum allows you to change the market CDS spreads. 14000
This provides you with the P/L on the position shown in the 12000
field Market Value. In order to value a Recovery Swap 10000
package you will need to value both the normal CDS and the 8000
DDS via the CDSW page. 6000
4000
We can also use the CDSW calculator to analyze the P/L 2000
sensitivity to implied recovery rates at various spread levels. 0
As shown in Chart 2, the P/L sensitivity on a DDS is broadly 20 40 60 80 100 120 140 160 180 200 220 240
Source: JPMorgan
5
Credit Derivatives Strategy
sure to have a fixed pay off following a Credit Event rather the creditor ranking from senior unsecured debt and may or
than having the additional exposure to recovery rates. may not be linked to senior unsecured recovery rates should
company ABC default. Irrespective of this, the corporate in
A specific example of bank credit exposure independent of question may prefer a credit contingent fixed payout through
recovery rates is that of off-setting CDS positions. Imagine a DDS rather than additional recovery rate exposure in the
a bank buys CDS protection at 100bp and, following credit CDS instrument. The hedge ratio applied should naturally
spread widening, sells CDS protection at 200bp in equal be adjusted to reflect the expected recovery rate on the
notional sizes. This position has a mark-to-market gain in accounts receivables. For instance, if the corporate expects
the form of a risky stream of future cash flows - if the to get 20% of accounts receivable back following default, it
Reference Entity experiences a Credit Event, both CDS are should use an 80% hedge ratio - in other words buy $8m of
triggered, resulting in zero profit on the position irrespective DDS protection on $10m accounts receivables.
of the recovery rate. This is a pure credit contingent loss Many of the uses of DDS described above naturally work
and could be hedged by buying DDS protection with a better on single name DDS rather than on DDS based index
notional equivalent to the mark-to-market on the position products such as DDS DJ TRAC-X Europe and DJ
(for the hedge to work perfectly, the notional would have to CDX.NA.IG. As we have seen on, for example, DJ TRAC-X
be changed as CDS spreads change, as rates change, and as Europe 10Y and HY, index trading can significantly increase
the maturity on the CDS decreases). the trading volume in the underlying single name CDS. As
volumes on DDS-based indices and Recovery Swaps
In our view, corporates can also benefit from the use of DDS. increase, we would likewise expect improved liquidity in the
Consider a corporate with accounts receivables of $10m from underlying single name DDS as well.
company ABC. Accounts receivables stand differently in
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6 19 May 2004