liam_mescall_cds_trading_1

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CDS Trading Project

Name: Liam Mescall

Student ID: 0144126

Bertelsmann AG are a German based, privately controlled media conglomerate operating in

63 countries worldwide generating revenue from radio, book and magazine publishing,

media, communication, internet publishing and distribution.

Trade:Sell 10m of CDS protection on 10 year Bertelmann AG trading at 90.11 bps. The

trade will take place at par, no upfront transaction.

Trade rational

CDS Spread Correlation with Equity Prices

The relationship between CDS spread and equity price is such that an increase in the equity

value has a commensurate decline in CDS spread (1). This is broadly reflected graphically

here with empirical research performed supporting this theory (refer attached paper).

Assuming this relationship holds I see the equity price rising, and a corresponding tightening

of the CDS spread, for the following reasons:

2006

2007

2008

2009

2010

3080

130180230280330380430

480

Equity Price V's CDS Spread

Spread Price


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Consistent low debt/equity ratio considering the broad range of industries withdifferent capital intensities. Further decline is expected with CFO, Thomas Rabe,

announcing in past week that all debt could be repaid by 2014, 1.5bn to be repaid

early (49% of current debt). Company are currently in discussions with ratings

agencies over possible upgrade. After early bond payment of 800m in last months

(20% of then debt).

Raised profit forecast by 20% for 2010 after first half results. Advertising revenuesare key to profitability which is returning to pre-2007 levels.

Cost cutting has seen employees reduced by 2,603 since prior year (2.5%) andcompany focus is to get used to media as a low cost industry. Rising revenues and

falling costs increase profitability.

Worldwide location offers diverse geographical revenue base, this offers moreexposure to global economic conditions which have been improving. Entered the

pharmaceutical distribution and music rights markets, further diversifying revenues.

BRIC countries offer growth areas into the medium term with overhaul of Egypt andpotential for larger Middle Eastern countries (Iran, Libya protesting) to follow which

would relax censorship, opening potential new markets.

Recovery Rate and Default Probabilities

Also I consider the recovery rate to be mispriced following analysis of the companys

financial position. The rate assigned is a generic 40% rate used for corporates. Analysis of the

companys balance sheet shows that the company is cash rich and could currently pay 33% of

Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

0.51.52.53.54.55.56.57.5

Capital Formation Ratios

LT Debt/Equity Ratio Debt to Cash Ratio


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outstanding debt from cash reserves. At least 10% should be retrieved from the sale of the

other assets even at Firesale prices, leaving a minimum recovery rate of 43%. Taking the

minimum recovery rate to be 43%, anticipating the market to price this correction in, a

repricing of the security sees a parallel shift as per graph below (refer appendix 2 for code):

In addition, recalculated default probabilities (using market observable spreads) suggest the

chance of default is marginally lower than stated on Reuters. I am unsure how Reuters

calculates this value, bootstrapping to recalculate (in MatLab) is an appropriate comparison

as it uses market observable data. This shows a marginally smaller chance of default by

roughly .35% (15.35% chance per Reuters). Assuming the spread is calculated using the

formula:

Spread = Default Probability (1Recovery Rate)

I expect to see a correction to a lower default probability which will lower the spread and

with it the value of the security. See graph below (refer appendix 2 for code):

0 2 4 6 8 10 120

10

20

30

40

50

60

70

80

90

Time (years)

Spread(bp)

CDS Spreads with Different Recovery Rates

40%

43%


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Risks

Liquiditylimited chance I may not be able to enter in to opposing transaction.

Equity price falls does not rise. Market does not price in the recalculated default probability or recovery rate. Price rises with relationship between equity and CDS spread does not hold. Fraud, large scale litigation or any such breach of legislation/circumstance putting

finances under pressure and increasing spread or risk of default, pushing the curve

upwards and reducing the discounted cash flows/overall value.

Business tends to be cyclical; a severe double dip recession could see Bertelsmannstruggle with advertising revenues, a key driver of profitability.

Time decay is in my favour, with time passing the default probability reduces. No risknoted.

Choosing the ten year introduces a larger number of cash flows on which profit/losswill be made when discounting to arrive at price.

0 1 2 3 4 5 6 7 8 9 100

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

Time (years)

CumulativeDefaultProbability

Bootstrapped Default Probability Curve


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No FX impact as all bonds are issued in Euro.P&L

Profits were calculated by:

Getting the zero curve, default and survival probabilities for the CDS as of the24/7/2011.

Calculating the discount factor to be used from the E-RT formula. Rates used wereinterpolated from the zero curve for each quarterly payment with the time variable

being .25,.5,.75(refer appendix 2 for code)

PV01 is calculated by multiplying the discount factor by survival probabilities(interpolated using a spline, refer appendix 2 for code).

The NPV of each quarterly payment was then made by multiplying the PV01 by thechange in bps between the 17/2/2011 and 24/2/2011 spreads (i.e. 90bps=90/10,000).

This value is multiplied by the notional to arrive at total profit/loss.

A profit of 44,889.99 was made. Refer attached excel sheet for calculations.

12.7924.29

43.8154.11

67.01

80.2

91.46

11.42

23.26

42.4153.03

65.62

78.8390.11

1 YR 2 YR 3 YR 4 YR 5 YR 7 YR 10 YR

One Week Curve Comparison

17/2/2011 Curve 24/2/2011 Curve


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Experience Analysis

Noting the % change in spreads over the period along with the % difference betweenthe spreads we can see the short end of the curve is significantly more susceptible to

movements than the long end.

There appears to be unusual movement in the four and five year spreads relative todistance between 1 YR and 2YR, 2YR and 3YR and 7YR and 10 YR with 38% fall

and 4% increase noted. This may be a liquidity issue as the five year is by far the most

actively traded and may offer arbitrage opportunities going forward.

There is significantly less liquidity in the 10 YR market than that of the 5 YR. Therestill remains participants from which to enter into opposing transaction.

Time Start Spread End Spread % Change % Difference Between Spread Changes

1 YR 11.42 12.79 12.00% N/A

2 YR 23.26 24.29 4.43% -63.09%

3 YR 42.41 43.81 3.30% -25.45%

4 YR 53.03 54.11 2.04% -38.31%

5 YR 65.62 67.01 2.12% 4.01%

7 YR 78.83 80.2 1.74% -17.96%

10 YR 90.11 91.46 1.50% -13.80%


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Appendix

1. Bystorm, H (2005), CDS and Equity Prices: The iTraxx CDS Index Market, Lund University.Refer attached paper.

2.%% Bootstrapped Default Prob CurveSettle= '17-Feb-2010';MarketDates=datenum({'2-Aug-11','2-Aug-12','15-Dec-13','29-Apr-

15','10-Sep-16','23-Jan-18','7-Jun-19','19-Oct-20'});MarketSpreads=[12.79 24.29 43.81 54.11 67.01 80.2 91.46]';MarketData=[MarketDates MarketSpreads];ZeroDates=datenum({'23-Aug-11','23-Feb-12','25-Feb-2013','24-Feb-

2014','23-Feb-2015','23-Feb-2016','23-Feb-2018','24-Feb-2020'});ZeroRates=[1.63 1.69 2.09 2.39 2.65 2.86 3.21 3.45]'/100;ZeroData=[ZeroDates ZeroRates];[ProbData,HazData]=cdsbootstrap(ZeroData,MarketData,Settle);

ProbTimes = yearfrac(Settle,ProbData(:,1));figureplot([0; ProbTimes],[0; ProbData(:,2)])grid onaxis([0 ProbTimes(end,1) 0 ProbData(end,2)])xlabel('Time (years)')ylabel('Cumulative Default Probability')title('Bootstrapped Default Probability Curve')

%% Breakeven Spread for New ContractMaturity1=datestr(daysadd('17-Feb-2010',360*(.5:.25:10),1));Spread1 = cdsspread(ZeroData,ProbData,Settle,Maturity1);

%% Adjusted Recovery Rate ComparisonSpread1Rec35 = cdsspread(ZeroData,ProbData,Settle,Maturity1,...'RecoveryRate',0.5);

figureplot(yearfrac(Settle,Maturity1),Spread1, ...yearfrac(Settle,Maturity1),Spread1Rec35, '--')grid onxlabel('Time (years)')ylabel('Spread (bp)')title('CDS Spreads with Different Recovery Rates')legend('40%','50%','location','SouthEast')

3. %% Default Probabilitiess= [0.5; 1; 2; 3; 4; 5; 7; 10];

q=[.9992; .9974; .9909; .9763; .9616; .9411; .9033; .8465];

a=0:.25:10;

b=interp1(s,q,a,'spline');

%% Zero Rates

t=2011:1:2021;

p=[.0095493 .016152 .021097 .024147 .026541 .02862 .03044 .031864

.033101 .034159 .035117];

x=2011:90/360:2022; y=interp1(t,p,x,'spline');

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