IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Credit default swaps (CDS)
Ahmad Peivandi, Northwestern University
March 6, 2013
1 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Credit default swaps (CDS)
Ahmad Peivandi, Northwestern University
March 6, 2013
2 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Table of contents
1 Introduction
2 Current settlement mechanism in use
3 Goals of a mechanism
4 Results
3 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
What is a credit default swap?
Think of a �rm (R) that has issued bonds.
Assume agent B has purchased a number of bonds from �rm
R.
There is a risk that �rm R will go bankrupt and defaults.
Because of this risk �rm B purchases insurance from another
agent (S).
For an agreed period of time B pays a fee to agent S and in
return receives insurance against default risk.
If default happens �rm S compensate B for his loss.
(Numerical example) Amount of outstanding CDSs is more
than 30 trillion USD!
4 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
CDS settlement
From now on assume that the default has happened.
The question is how to settle these contracts?
Agent B hands his defaulted bonds to S and gets the face
value. This is called physical settlement.
Assume the face value is 100. If the defaulted bond price in
the market was p, S has to pay B 100− p. This is called cash
settlement.
5 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
CDS settlement
From now on assume that the default has happened.
The question is how to settle these contracts?
Agent B hands his defaulted bonds to S and gets the face
value. This is called physical settlement.
Assume the face value is 100. If the defaulted bond price in
the market was p, S has to pay B 100− p. This is called cash
settlement.
5 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
CDS settlement
From now on assume that the default has happened.
The question is how to settle these contracts?
Agent B hands his defaulted bonds to S and gets the face
value. This is called physical settlement.
Assume the face value is 100. If the defaulted bond price in
the market was p, S has to pay B 100− p. This is called cash
settlement.
5 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
CDS settlement
From now on assume that the default has happened.
The question is how to settle these contracts?
Agent B hands his defaulted bonds to S and gets the face
value. This is called physical settlement.
Assume the face value is 100. If the defaulted bond price in
the market was p, S has to pay B 100− p. This is called cash
settlement.
5 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Physicall settlement vs cash settlment
Physical settlement seems to be natural solution for
settlement. However, number of issues that may arise.
1) It constrain the number of CDS contracts to number of
defaulted bonds. There maybe naked CDS.
2) Even if agents could purchase defaulted bonds it would
arti�cially raise the price of bonds.
3) Short-selling is impossible or very hard.
For these reasons cash settlement has merged.
These defaulted bonds are not traded in a liquid market,
therefore, value of these defaulted bonds are not known.
The challenge is to determine a price for the defaulted bond.
6 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
How does it work?
The mechanism determines a price and quantities for cash
settlement.
Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them
will be settled via cash settlement and the rest, 8− 5, via
physical settlement.
The current mechanism in use is a two stage mechanism.
In the �rst stage the mechanism determines a price �oor or
ceiling and also determines the number of defaulted bonds for
buy or sell.
In the second period a uniform price auction determines the
price of the defaulted bond.
7 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
How does it work?
The mechanism determines a price and quantities for cash
settlement.
Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them
will be settled via cash settlement and the rest, 8− 5, via
physical settlement.
The current mechanism in use is a two stage mechanism.
In the �rst stage the mechanism determines a price �oor or
ceiling and also determines the number of defaulted bonds for
buy or sell.
In the second period a uniform price auction determines the
price of the defaulted bond.
7 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
How does it work?
The mechanism determines a price and quantities for cash
settlement.
Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them
will be settled via cash settlement and the rest, 8− 5, via
physical settlement.
The current mechanism in use is a two stage mechanism.
In the �rst stage the mechanism determines a price �oor or
ceiling and also determines the number of defaulted bonds for
buy or sell.
In the second period a uniform price auction determines the
price of the defaulted bond.
7 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
How does it work?
The mechanism determines a price and quantities for cash
settlement.
Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them
will be settled via cash settlement and the rest, 8− 5, via
physical settlement.
The current mechanism in use is a two stage mechanism.
In the �rst stage the mechanism determines a price �oor or
ceiling and also determines the number of defaulted bonds for
buy or sell.
In the second period a uniform price auction determines the
price of the defaulted bond.
7 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
How does it work?
The mechanism determines a price and quantities for cash
settlement.
Ex: p = 70 and q = 5. If he has 8 CDSs contracts 5 of them
will be settled via cash settlement and the rest, 8− 5, via
physical settlement.
The current mechanism in use is a two stage mechanism.
In the �rst stage the mechanism determines a price �oor or
ceiling and also determines the number of defaulted bonds for
buy or sell.
In the second period a uniform price auction determines the
price of the defaulted bond.
7 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Comments on the existing mechanism
Rigged in the favor of artitechts who make money from this
mechanism.
Gupta et al, (2012) have observed that the defaulted bonds in
this mechanism are under priced in the vast majority of
auctions.
Underpricing implies that the protection buyer cannot fully
insure against the risk of default by the reference asset.
This comes at the cost of e�ciency loss.
In an e�cient allocation risk neutral agents (protection sellers)
should provide full insurance for risk averse agents (protection
buyers) against the default risk.
8 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Comments on the existing mechanism
Rigged in the favor of artitechts who make money from this
mechanism.
Gupta et al, (2012) have observed that the defaulted bonds in
this mechanism are under priced in the vast majority of
auctions.
Underpricing implies that the protection buyer cannot fully
insure against the risk of default by the reference asset.
This comes at the cost of e�ciency loss.
In an e�cient allocation risk neutral agents (protection sellers)
should provide full insurance for risk averse agents (protection
buyers) against the default risk.
8 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Comments on the existing mechanism
Rigged in the favor of artitechts who make money from this
mechanism.
Gupta et al, (2012) have observed that the defaulted bonds in
this mechanism are under priced in the vast majority of
auctions.
Underpricing implies that the protection buyer cannot fully
insure against the risk of default by the reference asset.
This comes at the cost of e�ciency loss.
In an e�cient allocation risk neutral agents (protection sellers)
should provide full insurance for risk averse agents (protection
buyers) against the default risk.
8 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Comments on the existing mechanism
Rigged in the favor of artitechts who make money from this
mechanism.
Gupta et al, (2012) have observed that the defaulted bonds in
this mechanism are under priced in the vast majority of
auctions.
Underpricing implies that the protection buyer cannot fully
insure against the risk of default by the reference asset.
This comes at the cost of e�ciency loss.
In an e�cient allocation risk neutral agents (protection sellers)
should provide full insurance for risk averse agents (protection
buyers) against the default risk.
8 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Comments on the existing mechanism
Rigged in the favor of artitechts who make money from this
mechanism.
Gupta et al, (2012) have observed that the defaulted bonds in
this mechanism are under priced in the vast majority of
auctions.
Underpricing implies that the protection buyer cannot fully
insure against the risk of default by the reference asset.
This comes at the cost of e�ciency loss.
In an e�cient allocation risk neutral agents (protection sellers)
should provide full insurance for risk averse agents (protection
buyers) against the default risk.
8 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Incentives and detail free
1 Ex-post incentive compatible, this means that the
mechanism is incentive compatible for all possible agents'
belief.
2 Detail free, which means that the settlement mechanism does
not depend on the functional form of the agents' valuation of
the defaulted bond.
9 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Budget balanced and Unbiased
1 Weakly budget balanced, which means that the designer
does not have to incur a monetary cost to run this settlement
mechanism.
2 Unbiased, this means that from the designer's view point.
The expected pay-o� induced by this mechanism is equal to
that of a mechanism that sets the cash settlement price equal
to the value of the defaulted bond.
10 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Main result
A �xed price mechanism satis�es all four properties.
price=the expected value of price.
Almost surely, these are the only mechanisms with these
properties.
Intuitively, this result suggests that auctions or any mechanism
that depends on agents' information can not achieve those
four goals.
11 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Main result
A �xed price mechanism satis�es all four properties.
price=the expected value of price.
Almost surely, these are the only mechanisms with these
properties.
Intuitively, this result suggests that auctions or any mechanism
that depends on agents' information can not achieve those
four goals.
11 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Main result
A �xed price mechanism satis�es all four properties.
price=the expected value of price.
Almost surely, these are the only mechanisms with these
properties.
Intuitively, this result suggests that auctions or any mechanism
that depends on agents' information can not achieve those
four goals.
11 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Participation
ISDA does not force participation in this mechanism. If both
parties of a CDS contract agree, they can settle their contracts
using another mechanism.
This mechanism leaves no incentive for agents to not
participate in the mechanism.
12 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
Participation
ISDA does not force participation in this mechanism. If both
parties of a CDS contract agree, they can settle their contracts
using another mechanism.
This mechanism leaves no incentive for agents to not
participate in the mechanism.
12 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
suggestion
Use rating agencies or other �nancial institutions to price the
auction.
13 / 14
IntroductionCurrent settlement mechanism in use
Goals of a mechanismResults
References
Participation and unbiased pricing in CDS settlement
mechanisms. Ahmad Peivandi.
M. Chernov, A.S. Gorbenko, and I. Makarov, CDS Auctions,
working paper 2012.
V. Coudert, M. Gex, The Credit Default Swap Market and the
Settlement of Large Defaults, working paper no. 2010-17,
CEPII.
S. Du, H. Zhu, Are CDS Auctions Biased? working paper,
Stanford GSB, 2010.
S. Gupta, R.K. Sundaram, CDS Credit-Event Auctions,
working paper 2012.
14 / 14
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