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CDO,CDS & IRSBy: Fahad Siddiqui

Meenakshi Chettiar

Priyanka Narvekar

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CDS

Credit Default Swap (CDS)

A contract designed to transfer the credit exposure of

debt obligation between parties.

The buyer of a credit swap receives credit protection,

whereas the seller of the swap guarantees the credit

worthiness of the underlying security.

In a CDS the risk of default is transferred from the

holder of the security to the seller of the swap.

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$ 1 Billion

10% p.a

1 % p.a

Pension Fund Corporation ABB Rating

Credit Rating

Agency

Insurance

Company (AIG)

AA Rating

Insuranceon As Debt

Working of CDS

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$1B 10%

1%I.A

$2B 12%

I.B

2%

Insurance on

B for$

10B

2% of$10B

= $200m

Credit

Rating

Agency

A B C

P1 P2Hedge

Fund

Insurer 1 Insurer 2

CDS Contd..

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Collateralized Debt Obligation

Collateralized Debt Obligation (CDO)

A structure used to distribute risk throughtranching a portfolio ofcredit, and issuing notes of

different risk profiles to investors.

Riskier tranches will earn a higher investorpremium, to reflect the higher risk.

CDO notes will typically be issued to the investorby an SPV.

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$ 1 million

(Loan)

10% p.a

Commercial

Bank

X 1000

Investment

Bank$ 1 Billion

Rights on Payment

10% of$1B =

$100m

Working of CDO

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X 1000

Investment

Bank

10% p.a

10% p.a

Special Purpose Entity

$100 m per year

$1 Billion @ end

of term

1 million

Notes

1 Share

Cash Flows:

$ 100 per year

$1000 @ term end

Investors

$1.1 Billion

@ $1100 per note

Mortgage Backed

Security

Rights on

Payments

CDO Contd

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SPELoans

Borrowers ($1m x

1000)

$1 B 10% = 100k

x

1000

----------= $100m

MBS

10% $1000 x 1m = $1B

20% Default

50% Recovery

--------------------

10% of the loans are

worthless

9%

Risk Averse

Investor

Investor OK

with Risk

CDO Contd

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Equity

Mezzanine

Senior

$300m

$300m

$400m

Borrowers ($1m x

1000)

$1 B$100m

$1000

$1000

$1000

$1k x 400k

= $400m

6% = $24m

$1k x 300k

= $300m

7% = $21m

$1k x 300k

= $300m

18.3% = $55m$50m

$5m

Mortgage Backed Collateralized Debt Obligation

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IRS

Interest Rate Swap

An agreement to exchange interest rate cash

flows, based on a specified notional amount from

a fixed rate to a floating rate (or vice versa) or

from one floating rate to another.

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Company A

(Utility)

Company B

(Cyclic)Wants Fixed Rate Wants Floating Rate

Bank Quotes Lower

Floating & Higher Fixed

Rate

Bank Quotes Lower

Fixed & Higher FloatingRate

BANK

Company A

(Utility)

Company B

(Cyclic)

MIBOR + 1.5% 10%

BANK8.5% MIBOR + 4.5%

* Assume MIBOR = 6%

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SWAP

A

B

(8%) (MIBOR + 1.5%)

(a) For A: (A gains 0.5%)

(b) For B: (B gains 1%)

Party Swap

Outflow %

Swap Inflow

%

Outflows on

Bank Loan

Total %

A -8 (MIBOR +

1.5%)

-(MIBOR +

1.5%)

-8

B -(MIBOR +

1.5%)

8 -10% -(MIBOR + 3.5%)

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