So I understand the concept of how CDO's emerged. Solomon trader L.Ranieri essentially invented the bond market for mortgages with all the tranches which created a market, eventually intermediaries pooled the bonds and made CDO's, specific to different tranches and re-packaged and subsequently regraded.

If I were to buy a CDS on a specific CDO of say 100 bonds of mortgages, and say mid-2007,

I bought the CDS on a specific CDO from BB X, whilst BB Y, actually owns the corresponding long trade on the specific CDO (If the firm I buy the CDS from must hold the specific CDO, then just use BB X)

So, over-night the CDO value falls 10%, does the CDS rise in value 10% and get sold on later on? (Wouldn't it go bust then the CDS would be worthless as couldn't sell it?)

Or, say, every night does the person who actually holds the CDO pay the CDS holder the difference? How much/what determines who and how often the CDS holder is paid assuming the CDO loses value as people default?

Regards, trying to understand this a bit better,

Region

Best Response

I'm not entirely sure, but CDS is basically insurance on a reference entity. So you buy CDS to insure against a default of the CDO (reference entity). The price of the CDS changes based on how the market perceives the price should be based on how much it should cost to insure against a default of the reference entity. I don't think there is a direct correlation that says if the CDO drops 10% then the CDS goes up 10%. But the directional correlation would be there, ie if the CDO value drops people are thinking it might default and the CDS price would rise... I could be completely wrong

The CDS is priced based on likelihood of default of the underlying financial instrument

Ex: You are buying 1-year CDS on 100mm of Company A's junior paper (expected recovery rate in bankruptcy = 0), and the cost is 300 bps/yr (3mm), then it means the market predicts that there is a ~3% chance the company defaults on the debt.

What you say sounds logical, thanks for the response. I'm a tad confused as to if the 'insurance' is paid by a firm that is related to the reference entity in some way, or the market just dictates the value of it and it gets sold on again. But on that last point, if the CDO collapsed all-together and was worthless, how could the holder of the CDS sell it? It'd be worth an incredible amount of money but since it couldn't go up any more as the CDO had failed then who'd buy it?

Thanks Solidarity, so if, for whatever reason, Company A's financials hit the fan, and the chance of defaults rose, to say, 5%, the CDS owner would have to pay 500 basis points a year? Is that when the typical CDS owner would sell (obviously dependent on strategy), i.e. does the higher cost imply a higher value for the overall CDS and that's when the profit is made?

regards

nabran:
Thanks Solidarity, so if, for whatever reason, Company A's financials hit the fan, and the chance of defaults rose, to say, 5%, the CDS owner would have to pay 500 basis points a year?

CDS are quoted as spot, but you actually pay a portion up-front and then a fixed (usually quarterly) run rate. It's a contract so you would still be paying 3%...

Is that when the typical CDS owner would sell (obviously dependent on strategy), i.e. does the higher cost imply a higher value for the overall CDS and that's when the profit is made?

Most companies hold the CDS to the underlying instrument as a way of hedging default risk. A lot of financial institutions do this to avoid over-exposure to any single company. However, you don't have to own the underlying instrument to buy a CDS, which was the crux of the whole CDO/meltdown controversy in 08-09 when companies sold 'cheap' CDS and then realized they would not be able to payout in a black swan event, and scrambled to buy CDS to even out their position.

I think if the CDO collapses, that qualifies as a triggering event that forces the counterparty to payout on the CDS - it's not being "sold" to anyone else

Yep, you delivere the instrument if the CDO collapses, and the value of the CDS is the difference b/w the face value and w/e the recovery rate is.

I think if the CDO collapses, that qualifies as a triggering event that forces the counterparty to payout on the CDS - it's not being "sold" to anyone else. The owner of the CDS would receive the pre-determined settlement in the event of a default or breach of some threshold previously agreed upon.

Disclaimer: I have only worked in the rates space, not credit derivatives.

People tend to think life is a race with other people. They don't realize that every moment they spend sprinting towards the finish line is a moment they lose permanently, and a moment closer to their death.
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