I am researching the subject of CDSs and so far I am behind on answers on a few questions I have where I can’t find anything on the internet. Any insight or links to documents you know about would be appreciated. - Collateral requirements for the CDS seller: Do they have to have collateral for 100% of the stuff they sell? Can entering in an offsetting position reduce the collateral required? How do they come up with the collateral and does it have to cover 100% the nominal value protected? - The unwinding we keep hearing about: What is unwinding? Does it refer to entering in offsetting positions or early termination of contracts? Most importantly what are the impacts of this and how would someone invest appropriately (what not to do, what to do). - The setting of the price the seller must pay: I read it is by reverse auction for the underlying bond, how exactly does this work?
Not an expert, but: You collateralise the value of the position, not the notional - so all of your other questions on collateral don’t mean much. I think questions 2 and 3 are about ISDA auctions when a credit event occurs. There is a primer here: http://www.creditfixings.com/information/affiliations/fixings/auctions/current/credit_event_auction_primer.pdf
for question 1, I don’t think you have to have any collateral to sell protection - that’s the problem we’re facing - if you sell protection on stuff that blows up, you get a “run” on teh banks cash and assets, and well, you get the picture. Some people do require it, but it’s usually self imposed, i.e., not a market requirement (unlike futures) unwinding is different then an offsetting position. An offsetting position still has couterparty risks, whereas unwinding you take all your risk off. In theory, the net economic effect if you take an offsetting position is zero, but you still have the positions and are exposed to the counterparty risk. not sure on 3
Agree with these guys. For #3, the process is covered in that document that chris posted. You probably don’t need all the details except that bond dealers bid on the bonds and they have incentives to bid fairly.
i don’t trade CDS but can’t you offset counterpary risk as long your counterparties agrees for you transfer the trade? For instance you sell to GS dealer protection on 5 yr Fords at 59 2 days later you then buy protection from DB dealer at 54. If you set this trade up with DB dealer they would transfer the risk and take you out of the picture and basically be buying from GS, and you just collect the proceeds. More likely then not, however, you would probably trade with the GS dealer to close the swap. I think the above trade scenario would benefit from regulation and a central reporting exchange, much like how futures are traded and regulated.
yeah, you can do that - it’s called a novation
- The colateral requirements that get posted depend on one’s specific ISDA agreement with the counterparty. Generally speaking the MTM p/l is posted at the end of each business day. To give an example…Let’s say you bot X @500 on the Thurs before LEH went bankrupt. The next day (Fri), the mkt closed on X @1000. LEH would have posted the risky PV of 500bp into ur account. Let’s say the following Monday (the day after LEH filed), the spread on X was now 1500. You are now an unsecured creditor to LEH for the risky PV of an additional 500bp. You have the first risky pv of 500bp sitting in ur account already. 2)Unwinding is simply going back to your dealer and offsetting your intial contracts. If I bot CDS @500, and it is now 1000, I can go sell it back to the dealer who makes me whole on the risky PV of 500bp. You have zero annuity, swap, or curve risk in this situation. You can also unwind by novating your contract to another deal (who you didnt initial enter the trade with). In these circumstances, another dealer makes u whole, just as though are unwinding in the example above, but rather than tearing the contract up, the new dealer assumes ur contract and is now facing the dealer with whom you initially entered into the contract (the dealer you assign it to has the same strike that you had as well - not the floating mkt rate at the time of novation). 3)I dont really feel like explaining, but bottom line is that anyone can submit bids for bonds and the lowest bid that captures all of the notional outstanding that is wishing to physically deliver will be the recovery rate. It is essentially a dutch.
With regard to 1) hedge funds when selling CDS can also skirt around collateral requirements with their prime brokers for individual positions through netting agreements. In these situations the PB analyses the portfolio of CDS positions as a whole and adjusts the total margin requirement accordingly. So if there were offsetting positions, there would be effectively no requirement to post any margin on these.
mib20 Wrote: ------------------------------------------------------- > 1) The colateral requirements that get posted > depend on one’s specific ISDA agreement with the > counterparty. Generally speaking the MTM p/l is > posted at the end of each business day. To give > an example…Let’s say you bot X @500 on the Thurs > before LEH went bankrupt. The next day (Fri), the > mkt closed on X @1000. LEH would have posted the > risky PV of 500bp into ur account. Let’s say the > following Monday (the day after LEH filed), the > spread on X was now 1500. You are now an > unsecured creditor to LEH for the risky PV of an > additional 500bp. You have the first risky pv of > 500bp sitting in ur account already. > > 2)Unwinding is simply going back to your dealer > and offsetting your intial contracts. If I bot > CDS @500, and it is now 1000, I can go sell it > back to the dealer who makes me whole on the risky > PV of 500bp. You have zero annuity, swap, or > curve risk in this situation. You can also unwind > by novating your contract to another deal (who you > didnt initial enter the trade with). In these > circumstances, another dealer makes u whole, just > as though are unwinding in the example above, but > rather than tearing the contract up, the new > dealer assumes ur contract and is now facing the > dealer with whom you initially entered into the > contract (the dealer you assign it to has the same > strike that you had as well - not the floating mkt > rate at the time of novation). > > 3)I dont really feel like explaining, but bottom > line is that anyone can submit bids for bonds and > the lowest bid that captures all of the notional > outstanding that is wishing to physically deliver > will be the recovery rate. It is essentially a > dutch. For 1) is the MTM on the p/l posted daily only for non collateralized trades? For 2) I was think unwinding on the part of the dealer, can the dealer buy out the existing CDS or can he just sell it to someone else (would this be novation?) Also, would you say most deals are or are not collateralized? Why would someone buy protection for a non collateralized dealer, are the premiums cheaper in that case? Thanks to all for the info.