Part 1 of this series of articles described the basic mechanics of a credit default swap.
Part 2 started to describe some of the changes in the market since part 1 was written. This part will continue that description by describing the upfront fee that is now paid on a standard CDS contract, and the impact of the changes on how CDS are quoted in the market.
Standard Premiums mean there is a Fee
Part 1 discussed how CDS contracts have been standardized. One of the ways in which they have been standardized is that there are now standard premiums.
Now consider the case where I buy protection on a five-year CDS. I enter into a standard contract with a premium of 500 basis points (5%). It may be that the premium I would have paid under the old nonstandard contract for the same dates and terms would have been 450 basis points. However, now I’m paying 500 basis points.
Clearly I need to be compensated for the 50 bps difference or I won’t want to enter into the trade under the new terms.
As a result an upfront fee is paid to me when the contract is started. This represents the 50 basis points difference over the life of the trade, so that I am paying the same amount overall as under the old contract.
Note that in this case I (the protection buyer) am receiving the payment, but it could easily be that I pay this upfront fee (if, for example, the nonstandard contract would have traded at 550 bps).
Upfront Fee Calculation
The calculation of the fee from the ‘old’ premium (spread) is not trivial. It takes into account discounting, and also the possibility that the reference entity will default, which would mean the premium would not be paid for the full life of the trade. However, this calculation too has been standardized by the contracts body (ISDA). There is a standard model that does it for us.
The Full First Coupon means there is a Fee
In the example in part 1 I discussed how I might pay for a full three months protection at the first premium payment date for a CDS trade, even though I hadn’t had protection for three months.
Once again I need compensation for this or I will prefer to enter into the old contract. So once again there is a fee paid to me when I enter into the trade.
This is known as an ‘accrual payment’ because of the similarity to accrued interest payment for bonds. Here the calculation is simple: it’s the premium rate applied to the face value of the trade for the period from the last premium payment date to the trade date.
That is, it’s the amount I’ll be paying for protection that I haven’t received as part of the first premium payment. Note no discounting is applied to this.
Upfront Fee/Accrual Payment
So in summary the new contract standardization means that a payment is now always made when a standard CDS contract is traded.
Part of the payment is the upfront fee that compensates for the difference between the standard premium (100 or 500 bps in North America) and the actual premium for the trade. This can be in either direction (payment from protection buyer to seller or vice versa). Part of the payment is the accrual payment made to the protection buyer to compensate them for the fact that they have to make a full first coupon payment.
How CDS are Quoted in the Market
Prior to these changes CDS were traded by simply quoting the premium that would be paid throughout the life of the trade.
With the contract standardization clearly the premium paid through the life of the trade will not vary with market conditions (it will always be 100 or 500 bps in North America, for example), so quoting it makes little sense.
Instead the dealers will quote one of:
a) Points Upfront
‘Points upfront’ or just ‘points’ refer to the upfront fee as a percentage of the notional. For example, a CDS might be quoted as 3 ‘points upfront’ to buy protection. This means the upfront fee (excluding the accrual payment) is 3% of the notional. ‘Points upfront’ have a sign: if the points are quoted as a negative then the protection buyer is paid the upfront fee by the protection seller. If the points are positive it’s the other way around.
With price we quote ‘like a bond’. We take price away from 100 to get points:
That is, points = 100 – price. So in the example above where a CDS is quoted as 3 points to buy protection, the price will be 97. The protection buyer still pays the 3% as an upfront fee of course.
Dealers are so used to quoting spread that they have carried on doing so in some markets, even for standard contracts that pay a standard premium. That is they still quote the periodic premium amount you would have been paying if you had bought prior to the standardization. As already mentioned, there is a standard model for turning this number into the upfront fee that actually needs to be paid.
This part concludes the discussion of the changes in the mechanics of CDS trading since 2007. As you can see, in many ways the standardization of the CDS market has actually made it more complicated. The things to remember are that premiums, premium and maturity dates, and the amounts paid at premium dates have all been standardized in a standard contract. This has meant there is an upfront fee for all standard CDS, and that they are quoted differently in the market from before. It has also meant that CDS positions can be more easily netted against each other, and that the mechanics of calculating and settling premiums have been simplified.
Part 4 of this series will examine some of the other changes since 2007, and changes that are coming.