CFA, FRM

First to Default CDS – Explained with Example

What is First to Default CDS?

First to Default CDS is a variant of the credit default swap. Credit Protection cease to exist when the CDS on the First Asset within the Portfolio is triggered.

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Example of First-to-Default CDS

Here, the bank holds a portfolio of four high-yield loans rated B, each with a nominal value of $100 million, a maturity of five years, and an annual coupon of LIBOR plus 200 basis points (bp).

In such deals, the loans are often chosen such that their default correlations are very small-Le., there is a very low probability at the time the deal is struck that more than one loan will default over the time until the expiration of the put in, say, two years.

First to Default CDS

A first-to-default put gives the bank the opportunity to reduce its credit risk exposure: it will automatically be compensated if one of the loans in the pool of four loans defaults at any time during the two-year period. If more than one loan defaults during this period, the bank is compensated only for the first loan that defaults.

If default events are assumed to be uncorrelated, the probability that the dealer (protection seller) will have to compensate the bank by paying it par-that is, $100 million-and receiving the defaulted loan is the sum of the default probabilities or 4 percent.

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 This is approximate, at the time, the probability of default of a loan rated B for which the default spread was 400 bp, or a cost of 100 bp per loan, half the cost of the protection for each individual name.

Note that, in such a deal, a bank may choose to protect itself over a two-year period even though the loans might have a maturity of five years. First-to-default structures are, in essence, pairwise correlation plays.

The first-to-default spread will lie between the spread of the worst individual credit and the sum of the spreads of all the credits-closer to the latter if the correlation is low and closer to the former if the correlation is high.

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