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Credit default swap (CDS)

1) What is a credit default swap (CDS)? Consider the cash-flow pattern of the CDS in Exhibit 2 of From free lunch to black hole: Credit Default Swaps at AIG Can you set up a trading strategy using long and short positions of the default-free floating rate bond and the defaultable floating rate bond that replicates the cash flow pattern of the CDS? Given the coupon rate on the defaultable floating rate bond, can you determine the CDS rate based on the law of one price?
2) Review Exhibits 3-6 of From free lunch to black hole: Credit Default Swaps at AIG. What was AIG’s role in the process of mortgage securitization? How did the Bistro deal work? How does the mortgage securitization work? What are super-senior tranches and what is their purpose?

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Sample Answer

 

 

1a. Credit Default Swap (CDS):

A CDS is a financial derivative contract where one party (protection buyer) pays a premium to another party (protection seller) in exchange for protection against the default of a specific underlying asset (reference entity). If the reference entity defaults, the protection seller compensates the protection buyer for the notional amount of the contract.

1b. Cash Flow Replication:

The cash flows of a CDS can be replicated using a combination of long and short positions in the default-free and defaultable floating-rate bonds with the same maturity as the CDS.

Full Answer Section

 

 

 

  • Long defaultable bond: Generates coupons and principal at maturity if no default occurs.
  • Short default-free bond: Offsets the coupons of the defaultable bond, but requires periodic payments equal to the default-free rate on the notional amount.
  • Additional cash flow: In case of default, the long defaultable bond receives only a fraction of the principal (recovery rate) while the short default-free bond requires no further payments. This difference compensates for the protection provided by the CDS.

1c. CDS Rate and Law of One Price:

Under the law of one price, identical assets with different names should have the same price. When replicating the CDS cash flow, the cost of buying the defaultable bond and shorting the default-free bond should equal the cost of buying the CDS. This allows you to solve for the CDS spread (premium) based on the observed market prices of the bonds and the recovery rate in case of default.

Disclaimer: This is a simplified explanation, and real-world CDS pricing involves additional factors like credit spreads, liquidity adjustments, and counterparty risk.

2. AIG’s Role and Mortgage Securitization

2a. AIG’s Role:

AIG was deeply involved in the mortgage securitization process through its Financial Products subsidiary. They acted as both issuers of mortgage-backed securities (MBS) and as protection sellers in CDS contracts referencing subprime mortgage pools.

2b. Bistro Deal:

In the Bistro deal, AIG created a complex CDS transaction where they sold protection on a portfolio of subprime MBS but hedged their risk by buying protection on smaller, riskier tranches of the same pool. This created an excessive concentration of risk within AIG, exposing them heavily to the subprime mortgage crisis.

2c. Mortgage Securitization:

Mortgage securitization involves pooling mortgages, dividing them into tranches with different risk profiles, and selling them to investors as securities.

  • Super-senior tranches: These represent the highest-rated and least risky portions of the pool, receiving principal and interest payments first in case of defaults.
  • Junior tranches: These represent the riskiest portions of the pool, receiving payments only after senior tranches are paid in full. Their higher risk is compensated by higher potential returns.

Disclaimer: This is a concise overview, and the process of mortgage securitization and financial engineering employed by AIG can be quite complex.

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