Schweser has this example: "The rose foundation enters into a 2 year CDS on a notional principal of \$10 million of 5 year bonds issued by the cresent corporation. Assume that the cresent corporation defaults at the end of the first year and the bonds are trading at 60 cents to the dollar. If cresent corporation defaults at the end of the first year, describe the cash flows associated with it"

The answer is (1-0.6) * \$10 million = \$4 million.

I know the above calculation is something very simple but I’m not getting it. Can someone please explain?

You’ll be able to recover 60% of the value of the portfolio by selling the assets and the CDS issuer will pay you \$4million. Therefore, you got all your money back.

Remember that credit risk is a function of probability of default and estimated amount to be recovered. So when the issuer of your bond defaulted on his obligation, it doesn’t mean the value of your asset is zero.

Alternatively, the CDS isssuer may require you to deliver the asset worth \$6m and then pay you \$10m. Net effect is you get \$4m from the CDS issuer.

My understanding was that ‘cresent corporation defaults’ meant the company defaulted on coupon payments. I don’t understand ‘trading at 60 cents to dollar’ part too. How did you conclude that 40 percent has to be payed by the issuer?

It’s similar to cash settlement, where they will net the value of the bonds \$6m against the insured amount of \$10m. Net effect is that you’ll be made whole for the loss in the value of crescent bonds of \$4m.

The trading price is given. It still have value to some investors such as distressed securities investors who are willing to wait for the liquidation of cresecent’s assets.

Or the company may only be suffering from short-term liquidity but is really solvent.

Look at it this way, you bought \$10m worth of bonds at 100 (par). As the company’s situation started to look worse and worse, the price of those bonds moves downward from 100 to 60 (higher risk of default, etc), When the default occurs, the CDS seller is going to “true you up”, by saying what you own is worth 60, so we owe you 40.

Obviously a bit more complex than this, but thats the theory behind it.

Bonds are 60 decents to the dollar, which means they lost 40 decents to the dollar.

40 cents loss * \$10 million = \$4 million loss.

Going long a CDS protects you from losses, so you gain \$4 million from the CDS.

CDS is a put option on the stock , with the excercise set to a condition of default. The holder ( Crescent ) has the right to put the stock back to the CDS seller at the strike price ( which is the notional on the contract ), when a default occurs .The stock is worth 60% of the notional at default and the CDS is cash settled. The stock transfers to the credit option seller.

Well, they’re bonds, but ok. Crescent is the reference entity and isn’t holding anything