7.2

Front 1

Distinguish between a CDS and a TRS

Back 1

A credit default swap only makes a payment if a credit event occurs. In a total return swap, the swap buyer receives the total return of the reference asset regardless of whether a credit event occurs

Front 2

three major categories of credit derivaties

Back 2

1. single-name vs multi-name instruments. single name instruments reference a single entity, while multi-name instruments reference multiple entities.
2. funded or unfunded. funded credit instruments involve the transfer of notional principal, while unfunded instruments do not.
3. Non-sovereign entities (i.e., corporations) versus sovereign entities (i.e., governments

Front 3

Four major stages of credit dervatives

Back 3

Stage 1: Defensive Stage (late 1980s - early 1990s)
Stage 2: Emergence of Intermediaries (1991 - late 1990s)
Stage 3: Development of Regulations (late 1990s - 2002)
Stage 4: Liquid Market (2003 - present)

Front 4

The protection buy'er counterparty risk can develoop in two ways

Back 4

1. The reference entity suffers a credit event resulting in default, and the protection seller also defaults. the probability of a double default can be high if the reference entity and protection seller have similar macroeconomic exposures.
2. Even without default from the underlying, the protection buyer faces counterparty risk. if the creditworthiness of the credit protection seller declines, the market value of the CDS will decline, resulting in a loss for the credit protection buyer

Front 5

Basis risk

Back 5

is the risk that the value of the CDS and the value of the asset that is being hedged are not perfectly correlated. This occurs when the protection buyer enters into a Credit Default Swap with a reference entity or asset that does not match the asset being held. A protection buyer may enter into a CDS with a different reference entity or asset because the CDS has higher liquidity than a similar CDS with the exact reference asset

Front 6

The growth in the CDS market is a result of the following five factors

Back 6

1. Credit derviatives can efficiently isolate pure credit risk
2. synthetic short credit positions can be implemented cheaply and efectively
3. Credit derivatives can synthetically create credit exposure without owning the underlying asset
4. Credit derivatives serve as a link between bond, loan, equity , and structure product markets.
5. Credit derivatives can provide much needed liquidity, particularly during market stress.

Front 7

Five key types of terms that are negotiated between the CDS buyer and the seller:

Back 7

1. CDS spread
2. Contract size and maturity
3. payment trigger events
4. Method settlement
5. Choice of assets to deliver

Front 8

Four key paramters that define a CDS

Back 8

1. Credit reference
2. notional amount
3. CDS spread
4.CDS maturity

Front 9

CDS indices

Back 9

CDS indices are equal-weighted baskets of a single-name CDS that are tradable. The two most common indices are CDS (North America and emerging markets) and iTraxx (Europe and Asia) indices, and both consist of 125 single-name CDSs.

Front 10

six major participants in the credit derivatives market

Back 10

1. bank trading activities
2. bank loan portfolio managers
3. Hedge funds
4. Asset maangers
5. Insurance companies
6. corporations

Front 11

Motifivations for entering into CDSs (5)

Back 11

* Isolation of credit risk
* Efficeint shorting of credit risk
* ease of establishing synthetic positions
* linking of markets
* liquidity during periods of market stress

Front 12

Credit linked notes

Back 12

CLNs offer investors higher coupon interest in exchange for bearinga portion of the credit risk associated with the note

Front 13

the major risks associated with credit derivatives are:

Back 13

1. operational risk
2. liquidity risk
3. pricing/model risk

Front 14

Risks of CDS include

Back 14

1. Counterparty risk. both protection buyers and protection sellers face counterparty risk. The more obvious case is when the protection buyer does not receive its promised payment in default on the reference entity from the protection seller
2. Basis risk: The risk that the value of the CDS and the value of the asset being hedged are not perfectly correlated. This occurs when the reference asset of the CDS is not the same as the asset being hedged.