《债券市场：分析与策略（第七版）》Ch30

Chapter30

CreditDerivatives

30-1Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallLearningObjectivesAfterreadingthischapter,youwillunderstandwhatacreditderivativeisthedifferenttypesofcreditriskwhatanassetswapiswhatacreditdefaultswapisandhowacrediteventcanbedefinedthedifferencebetweenasingle-namecreditdefaultswapandabasketdefaultswapthevaluationofasingle-namecreditdefaultswapwhatacreditdefaultindexis30-2Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallLearningObjectives(continued)Afterreadingthischapter,youwillunderstandcreditdefaultswapsonmunicipalsecurities,asset-backedsecurities,andcreditdebtobligationswhatatotalreturnswapisandthetypesofriskfacedinsuchaswapthedifferenttypesofcreditoptionswhatacreditforwardissecuritiesthatarecreatedusingcreditderivatives:syntheticcollateralizeddebtobligationsandcredit-linkednotes30-3Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallTypesofCreditRiskAninvestorwholendsfundsbypurchasingabondissueisexposedtothreetypesofcreditrisk:defaultriskcreditspreadriskdowngraderisk.Defaultriskisthecreditriskthattheissuerwillfailtosatisfythetermsoftheobligationwithrespecttothetimelypaymentofinterestandrepaymentoftheamountborrowed.Creditspreadriskistheriskthatanissuer’sdebtobligationwillperformpoorlyrelativetootherbondsduetoanincreaseinitscreditspread.Ifthecreditspreadincreases,themarketpriceofthebondissuewilldecline(assumingTreasuryrateshavenotchanged).Downgraderiskreferstoanunanticipateddowngradingofanissueorissuerthatwillcausethecreditspreadtoincreaseresultinginadeclineinthepriceoftheissueortheissuer’sbonds.Downgraderiskiscloselyrelatedtocreditspreadrisk.30-4Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallCategorizationofCreditDerivativesThereareseveralwaystocharacterizecreditderivatives.OnesuchcategorizationisshowninExhibit30-1(seeOverhead30-6).Asweshallsee,someofthederivativesdescribedintheexhibitarenottruecreditderivativesinthattheydonotprovideprotectionagainstcreditrisk.Rather,theyprovideprotectionagainstbothinterestrateriskandcreditspreadrisk.Thisappliestoassetswapsandtotalreturnswaps.Creditdefaultproductsprovideprotectionagainstcreditevents.30-5Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallExhibit30-1

CategorizationofCreditDerivatives

CreditDerivativesAssetSwapsTotalReturnSwapsCreditDefaultProductsCreditSpreadProductsCreditDefaultSwapsDefaultOptionsCreditSpreadForwardsCreditSpreadOptions

SingleNameSwapIndexSwapsUnderlyingiscredit-riskybondUnderlyingisacreditspreadBasketSwaps30-6Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorizationPriorto1998,thedevelopmentofthecreditderivativesmarketwashinderedbythelackofstandardizationoflegaldocumentation.Everytrade(i.e.,thebuyingandsellingofacreditderivativecontract)hadtobecustomized.In1998,theInternationalSwapandDerivativesAssociation(ISDA)developedastandardcontractthatcouldbeusedbypartiestotradesofacreditderivativescontract.Whilethedocumentationisprimarilydesignedforcreditdefaultswapsandtotalreturnswaps,thecontractformissufficientlyflexiblesothatitcanbeusedfortheothercreditderivativesdescribedinthischapter.30-7Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorization(continued)ReferenceEntityandReferenceObligationThedocumentationwillidentifythereferenceentityandthereferenceobligation.Thereferenceentityistheissuerofthedebtinstrumentandhencealsoreferredtoasthereferenceissuer.Itcouldbeacorporationorasovereigngovernment.Thereferenceobligation,alsoreferredtoasthereferenceasset,istheparticulardebtissueforwhichthecreditprotectionisbeingsought.Forexample,areferenceentitycouldbeFordMotorCreditCompany.ThereferenceobligationwouldbeaspecificFordMotorCreditCompanybondissue.30-8Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorization(continued)CreditEventsCreditdefaultproductshaveapayoutthatiscontingentuponacrediteventoccurring.The1999ISDACreditDerivativesDefinitions(referredtoasthe“1999Definitions”)providesalistofeightcreditevents:bankruptcycrediteventuponmergercrossaccelerationcrossdefaultdowngradefailuretopayrepudiation/moratoriumrestructuringTheseeighteventsattempttocaptureeverytypeofsituationthatcouldcausethecreditqualityofthereferenceentitytodeteriorate,orcausethevalueofthereferenceobligationtodecline.30-9Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorization(continued)CreditEventsBankruptcy

isdefinedasavarietyofactsthatareassociatedwithbankruptcyorinsolvencylaws.Failuretopayresultswhenareferenceentityfailstomakeoneormorerequiredpaymentswhendue.Whenareferenceentitybreachesacovenant,ithasdefaultedonitsobligation.Whenadefaultoccurs,theobligationbecomesdueandpayablepriortothescheduledduedatehadthereferenceentitynotdefaulted.Thisisreferredtoasanobligationacceleration.Areferenceentitymaydisaffirmorchallengethevalidityofitsobligation.Thisisacrediteventthatiscoveredbyrepudiation/moratorium.30-10Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorization(continued)CreditEventsArestructuring

occurswhenthetermsoftheobligationarealteredsoastomakethenewtermslessattractivetothedebtholderthantheoriginalterms.Thetermsthatcanbechangedwouldtypicallyinclude,butarenotlimitedto,oneormoreofthefollowing:areductionintheinterestrateareductionintheprincipalareschedulingoftheprincipalrepaymentschedule(e.g.,lengtheningthematurityoftheobligation)orpostponementofaninterestpaymentachangeinthelevelofseniorityoftheobligationinthereferenceentity’sdebtstructure30-11Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorization(continued)CreditEventsTheRestructuringSupplementtothe1999ISDACreditDerivativesDefinitions(the“SupplementDefinition”)issuedinApril2001providedamodifieddefinitionforrestructuring.Thereisaprovisionforthelimitationonreferenceobligationsinconnectionwithrestructuringofloansmadebytheprotectionbuyertotheborrowerthatistheobligorofthereferenceobligation.Thisprovisionrequiresthefollowinginordertoqualifyforarestructuring:theremustbefourormoreholdersofthereferenceobligationtheremustbeaconsenttotherestructuringofthereferenceobligationbyasupermajority(662/3%)Inaddition,thesupplementlimitsthematurityofreferenceobligationsthatarephysicallydeliverablewhenrestructuringresultsinapayouttriggeredbytheprotectionbuyer.30-12Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallISDACategorization(continued)CreditEventsInJanuary2003,theISDApublisheditsrevisedcrediteventsdefinitionsinthe2003ISDACreditDerivativeDefinitions.Themajorchangewastorestructuring,wherebytheISDAallowspartiestoagiventradetoselectfromamongthefollowingfourdefinitions:norestructuring“full”or“old”restructuring,whichisbasedonthe1993Definitions“modifiedrestructuring,”whichisbasedontheSupplementDefinition“modifiedmodifiedrestructuring.”ThelastchoiceisnewandwasincludedtoaddressissuesthataroseintheEuropeanmarket.30-13Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallAssetSwapsWhenaninvestorpossessesanassetandconvertsitscashflowcharacteristics,theinvestorissaidtohaveconstructedanassetswap.Acommonassetswapisforaninvestortopurchaseacredit-riskybondwithafixedrateandconvertittoafloatingrate.Iftheissuerofthebonddefaultsontheissue,theinvestormustcontinuetomakepaymentstothecounterpartyoftheinterest-rateswap(i.e.,theswapdealer)andisthereforestillexposedtothecreditriskoftheissuer.30-14Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallAssetSwaps(continued)Let’snowillustrateabasicassetswap.Supposethataninvestorpurchases$10millionparvalueofa7.85%,five-yearbondofaBBB-ratedutilitycompanyatparvalue.Thecouponpaymentsaresemiannual.Atthesametime,theinvestorentersintoafive-yearinterest-rateswapwithadealerwheretheinvestoristhefixed-ratepayerandthepaymentsaremadesemiannually.Supposethattheswaprateis7.00%andtheinvestorreceivessix-monthLIBOR.Let’slookatthecashflowfortheinvestoreverysixmonthsforthenextfiveyears:Thus,regardlessofhowinterestrateschange,iftheutilityissuerdoesnotdefaultontheissue,theinvestorearns85basispointsoversix-monthLIBOR.Receivedfromutilitybonds: 7.85%–Paymenttodealeronswap: 7.00%+Paymentfromdealeronswap:

6-monthLIBORNetreceivedbyinvestor: 0.85%+6-monthLIBOR30-15Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallAssetSwaps(continued)Effectively,theinvestorhasconvertedafixed-rateBBBfive-yearbondintoafive-yearfloating-ratebondwithaspreadoversix-monthLIBOR.Thus,theinvestorhascreatedasyntheticfloating-ratebond.Thepurposeofanassetswapistodopreciselythat:createasyntheticcredit-riskyfloating-ratesecurity.Whileinourdescriptionofanassetswaptheinvestorboughtthecredit-riskybondandenteredintoaninterest-rateswapwithadealer,anassetswaptypicallycombinesthesaleofacredit-riskybondownedtoacounterpartyatparandwithnointerestaccrued,withaninterest-rateswap.Thistypeofassetswapstructureorpackageisreferredtoasaparassetswap.Ifthereisadefaultbytheissuerofthecredit-riskybonds,theassetswaptransactionisterminatedandthedefaultedbondsarereturnedtotheinvestorplusorminusanymark-to-marketontheassetswaptransaction.Hencetheinvestorisstillexposedtotheissuer’screditrisk.30-16Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallAssetSwaps(continued)ThecoupononthebondintheparassetswapispaidinreturnforLIBOR,plusaspreadifnecessary.Thisspreadistheassetswapspreadandisthepriceoftheassetswap.IneffecttheassetswapallowsinvestorsthatpayLIBOR-basedfundingtoreceivetheassetswapspread.Thisspreadisafunctionofthecreditriskoftheunderlyingcredit-riskybond.30-17Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallAssetSwaps(continued)Toillustratethisassetswapstructure,supposethatinourpreviousillustrationtheswaprateprevailinginthemarketis7.30%ratherthan7.00%.Theinvestorownstheutilitybondsandsellsthemtoadealeratparwithnoaccruedinterest.Theassetswapagreementbetweenthedealerandtheinvestorisasfollows:Thetermisfiveyears.Theinvestoragreestopaythedealersemiannually7.30%.Let’slookatthecashflowfortheinvestoreverysixmonthsforthenextfiveyearsforthisassetswapstructure:Receivedfromutilitybonds: 7.85%–Paymenttodealeronswap: 7.30%+Paymentfromdealeronswap:

6-monthLIBOR+30basispointsNetreceivedbyinvestor: 0.85%+6-monthLIBOR30-18Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallAssetSwaps(continued)Inourfirstillustrationofanassetswap,theinvestoriscreatingasyntheticfloaterwithoutadealer.Theinvestorownsthebonds.Theonlyinvolvementofthedealerisasacounterpartytotheinterest-rateswap.Inthesecondstructure,thedealeristhecounterpartytotheassetswapstructureandthedealerownstheunderlyingcredit-riskybonds.Ifthereisadefault,thedealerreturnsthebondstotheinvestor.Therearevariationsofthebasicassetswapstructuretoremoveunwantednon-creditstructuralfeaturesoftheunderlyingcredit-riskybond.Thesimplestexampleofanassetswapvariationtoremoveanunwantednon-creditstructuralfeatureiswhenthebondiscallable.Ifthebondiscallable,thenthefuturecashflowsofthebondareuncertainbecausetheissuecanbecalled.Moreover,theissueislikelytobecalledifinterestratesdeclinebelowthebond’scouponrate.30-19Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallTotalReturnSwapsAtotalreturnswapinthefixed-incomemarketisaswapinwhichonepartymakesperiodicfloating-ratepaymentstoacounterpartyinexchangeforthetotalreturnrealizedonareferenceobligationorabasketofreferenceobligations.Whenthereferenceobligationisabondmarketindex,theswapisreferredtoasatotalreturnindexswap.Thepartythatagreestomakethefloatingpaymentsandreceivethetotalreturnisreferredtoasthetotalreturnreceiver.Thepartythatagreestoreceivethefloatingpaymentsandpaythetotalreturnisreferredtoasthetotalreturnpayer.30-20Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallTotalReturnSwaps(continued)Therearevariationsofthebasicassetswapstructuretoremoveunwantednoncreditstructuralfeaturesoftheunderlyingcredit-riskybond.Thesimplestexampleofanassetswapvariationtoremoveanunwantednon-creditstructuralfeatureisacallablebond.Inaswaption,aninvestorhastherighttoeffectivelyterminatetheswapfromthetimeofthefirstcalldateforthebondtothematuritydateofthebond.Becausetheinvestorispayingfixedandreceivingfloating,theswaptionmustbeoneinwhichtheinvestorreceivesfixedandpaysfloating.Credit-independentmarketriskistheriskthatthegenerallevelofinterestrateswillchangeoverthetermoftheswap.30-21Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallTotalReturnSwaps(continued)BenefitsofTotalSwapsThereareseveralbenefitsinusingatotalreturnswapasopposedtopurchasingreferenceobligationsthemselves.Thetotalreturnreceiverdoesnothavetofinancethepurchaseofthereferenceassets.Instead,itpaysafeetothetotalreturnpayerinreturnforreceivingthetotalreturnonthereferenceobligations.Thetotalreturnreceivercanachievethesameeconomicexposuretoadiversifiedbasketofassetsinoneswaptransactionthatwouldotherwisetakeseveralcashmarkettransactionstoachieve.Finally,aninvestorwhowantstoshortthecorporatebondwillfinditdifficulttodosointhecorporatebondmarket.Aninvestorcandosoefficientlybyusingatotalreturnswap.Inthiscasetheinvestorwilluseatotalreturnswapinwhichitisatotalreturnpayerandwillreceiveafloatingpayment.30-22Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallCreditDefaultSwapsThecreditdefaultswapismostpopulartypeofcreditderivative.Itsprimarypurposeistohedgethecreditexposuretoaparticularassetorissuer.Acreditdefaultswapinwhichthereisonereferenceobligationiscalledasingle-namecreditdefaultswap.Whenthereferenceobligationisabasketorportfolioofobligations(e.g.,10high-yieldcorporatebondof10differentissuers),itisreferredtoasabasketcreditdefaultswap.Inacreditdefaultswap,theprotectionbuyerpaysafeetotheprotectionsellerinreturnfortherighttoreceiveapaymentconditionalupontheoccurrenceofacrediteventbythereferenceobligationorthereferenceentity.Ifacrediteventoccurs,thentheprotectionsellermustmakeapayment.30-23Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallCreditDefaultSwaps(continued)Creditdefaultswapscanbesettledincashorbyphysicaldeliverywiththelatterbeingmoreefficient.Ifnocrediteventhasoccurredbythematurityoftheswap,bothsidesterminatetheswapagreementandnofurtherobligationsareincurred.Themethodsusedtodeterminetheamountofthepaymentobligatedoftheprotectionsellerundertheswapagreementcanvarygreatly.Acreditdefaultswapcanspecify(atthecontractdate)theexactamountofpaymentthatwillbemadebytheprotectionsellershouldacrediteventoccur.Conversely,thecreditdefaultswapcanbestructuredsothattheamountoftheswappaymentbythesellerisdeterminedafterthecreditevent.30-24Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwapThestandardcontractforasingle-namecreditdefaultswapcallsforaquarterlypaymentoftheswappremium.Thequarterlypaymentisdeterminedusingoneofthedaycountconventionsinthebondmarket.Theswappremiumpaymentforaquarteris:EXAMPLE.Assumeahypotheticalcreditdefaultswapwherethenotionalamountis$10millionandthereare92actualdaysinaquarter.Sincetheswappremiumis200basispoints(0.02),thequarterlyswappremiumpaymentmadebytheprotectionbuyeris:30-25Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)Intheabsenceofacreditevent,theprotectionbuyerwillmakeaquarterlyswappremiumpaymentoverthelifeoftheswap.Ifacrediteventoccurs,twothingshappen.First,therearenofurtherpaymentsoftheswappremiumbytheprotectionbuyertotheprotectionseller.Second,aterminationvalueisdeterminedfortheswap.Themarketpracticeforsettlementforsingle-namecreditdefaultswapsisphysicaldeliveryasopposedtoacashsettlement.Withphysicalsettlementtheprotectionbuyerdeliversaspecifiedamountofthefacevalueofbondsofthereferenceentitytotheprotectionseller.Theprotectionsellerpaystheprotectionbuyerthefacevalueofthebonds.Sinceallreferenceentitiesthatarethesubjectofcreditdefaultswapshavemanyissuesoutstanding,therewillbeanumberofalternativeissuesofthereferenceentitythattheprotectionbuyercandelivertotheprotectionseller.Theseissuesareknownasdeliverableobligations.30-26Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)Exhibit30-2(seeOverhead30-28)showsthemechanicsofasingle-namecreditdefaultswap.Single-namecreditdefaultswapscanbeusedinthefollowingwaysbyportfoliomanagers:Theliquidityoftheswapmarketcomparedtothecorporatebondmarketmakesitmoreefficienttoobtainexposuretoareferenceentitybytakingapositionintheswapmarketratherthaninthecashmarket.Conditionsinthecorporatebondmarketmaybesuchthatitisdifficultforaportfoliomanagertosellthecurrentholdingofacorporatebondofanissuerforwhichhehasacreditconcern.Ifaportfoliomanagerexpectsthatanissuerwillhavedifficultiesinthefutureandwantstotakeapositionbasedonthatexpectation,itwillshortthebondofthatissuer.However,shortingbondsinthecorporatebondmarketisdifficult.Theequivalentpositioncanbeobtainedbyenteringintoaswapastheprotectionbuyer.Foraportfoliomanagerseekingaleveragedpositioninacorporatebond,thiscanbedoneintheswapmarket.30-27Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallExhibit30-2MechanicsofaSingle-NameCreditDefaultSwapwithPhysicalDeliveryProtectionBuyerProtectionBuyerCashFlowsBeforeaCreditEventProtectionSellerQuarterlyswappremiumCashFlowsAfteraCreditEventQuarterlyswappremiumuptodateofcrediteventProtectionBuyerDateofcrediteventsFaceamountofbondsCashequaltofacevalueofbonds30-28Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)ApproximatingtheValueofaSingle-NameCreditDefaultSwapBy“valuing”or“pricing”asingle-namecreditdefaultswap,wemeanthedeterminationofthecreditdefaultswapspread.Webeginwithasetofsimplifyingassumptions.Refiningpricingmodelsforcreditdefaultswapstheninvolvesanalyzinghow,whentheassumptionsarerelaxed,themodelmustbealtered.Wewanttoknowhowthecreditdefaultswappremium,denotedbyS,ofasingle-namecreditdefaultswapwithamaturityofT

forsomereferenceentityisdetermined.30-29Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)ApproximatingtheValueofaSingle-NameCreditDefaultSwapConsiderthefollowingstrategy:Buythefloating-ratesecuritywithmaturityT

issuedbythereferenceentity.Fundthepurchaseofthefloating-ratesecuritybyborrowingforthelifeofthesecurity(whichisalsothelifeofthecreditdefaultswap),T,intherepomarket.Tohedgethecreditriskassociatedwiththefloating-ratesecurity,purchaseprotectionbybuyingacreditdefaultswapwithamaturityofT

onthereferenceentity.Thisstrategyisequivalenttoadefault-freeinvestment.Thepayoffforthetwopossibleoutcomes(nocrediteventoccursoracrediteventoccurs)isthesameatF–Biftheassumptionshold.30-30Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)ApproximatingtheValueofaSingle-NameCreditDefaultSwapFornoarbitragetooccurforourstrategyandwithoursetofsimplifyingassumptions,thecreditdefaultswapspread,S,mustbeequaltothepayoffunderbothscenarios,F

–

B.Thus,afirstapproximationofthecreditdefaultswapspreadisthedifferencebetweenthespreadoverLIBORatwhichthereferenceentitycouldissueaparfloating-ratesecurity(F)andthespreadoverLIBORforthefundingcosttoborrowthatfloating-ratesecurity(B).Thisfirstapproximationprovidesastartingpointformarketparticipantsastowhereacreditdefaultswapshouldtrade.30-31Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)BasketCreditDefaultSwapsWithabasketcreditdefaultswap,thetimeofthepayoutmustbespecified.Basketdefaultswapscanbestructuredindifferentways.Thesimplestcaseisthatifanyofthereferenceobligationsdefault,thereisapayoutandthenterminationoftheswap.Thistypeofswapisreferredtoasafirst-to-defaultbasketswap.Ingeneral,ifittakeskreferenceobligationstotriggerapayout,theswapiscalledak-to-defaultbasketswap.30-32Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)CreditDefaultSwapIndexInacreditdefaultswapindex,thecreditriskofastandardizedbasketofreferenceentitiesistransferredbetweentheprotectionbuyerandprotectionseller.Themechanicsofacreditdefaultswapindexareslightlydifferentfromthatofasingle-namecreditdefaultswap.Aswithasingle-namecreditdefaultswap,aswappremiumispaid.However,ifacrediteventoccurs,theswappremiumpaymentceasesinthecaseofasingle-namecreditdefaultswap.Incontrast,foracreditdefaultswapindex,theswappaymentcontinuestobemadebytheprotectionbuyer.However,theamountofthequarterlyswappremiumpaymentisreduced.Thisisbecausethenotionalamountisreducedasresultofacrediteventforareferenceentity.30-33Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)CreditDefaultSwapIndexExhibit30-3(seeOverhead30-35)showsthecashflowforagenericcreditdefaultindexswapafteracrediteventforonereferenceentity.Becauseacreditdefaultswapindexprovidesexposuretoadiversifiedbasketofcredits,itcanbeusedbyaportfoliomanagertohelpadjustaportfolio’sexposuretothecreditsectorofabondmarketindex.Byenteringintoacreditdefaultswapindexastheprotectionseller,aportfoliomanagerincreasesexposuretothecreditsector.Exposuretothecreditsectorisreducedbyaportfoliomanagerbeingtheprotectionbuyer.30-34Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallExhibit30-3MechanicsofaCreditDefaultIndexSwap(PhysicalDelivery)ProtectionBuyerProtectionBuyerCashFlowsBeforeaCreditEventProtectionSellerQuarterlyswappremiumCashFlowsAfteraCreditEventforReferenceEntityXInitialquarterlyswappremiumProtectionBuyerFaceamountofbondsofReferenceEntityXCashequaltofacevalueofbondsofReferenceEntityX

Revisedquarterlyswappremium

Dateofcreditevent30-35Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)CreditDefaultSwapsonNoncorporateReferenceEntitiesSincemid2000creditdefaultsswapsonnoncorporateentitieshavetraded.BelowwediscussMunicipalCreditDefaultSwapsandCreditDefaultSwapsonSecuritizedProducts.InregardstoMunicipalCreditDefaultSwaps,theISDAdocumentationanddefinitionofcrediteventshadlimitationsinitsapplicationtomunicipalentities.TheISDAreviseditsdocumentationanddefinitionstoaccommodatemunicipalentities.Notallofthesecrediteventsareapplicabletomunicipalentities.Thethreethatareusedascrediteventsinmunicipalcreditdefaultswapsarebankruptcyfailuretopayrestructuring30-36Copyright©2010PearsonEducation,Inc.PublishingasPrenticeHallSingle-NameCreditDefaultSwap(continued)CreditDefaultSwapsonNoncorporateReferenceEntitiesBecausecrediteventsmaynotapplytoalltypesofmunicipalbonds,theISDA’sstandardizedconfirmationformunicipalcreditdefaultswapsrequiresthatthepartiestoatradespecifythetypeofmunicipalbondthatistheunderlyingoneforatrade.TheISDAconfirmationprovidesthefollowingthreechoicesforthetypeofmunicipalbond:thosebackedbythefullfaithandcreditofthemunicipalgovernment(fullfaithandcreditobligations)thosepaidfromfundsonhand(generalfundobligations)thosebackedby