Sunday, March 29, 2009

Big Bang Theory: Fixing Annuity Risk by Recouponing CDS

Posted on "A Credit Trader":

Pop-quiz! In which market can you actually lose money by being too right? Well, credit derivatives, where else? Read on for an explanation.

One of the recent Big Bang changes in the CDS market has been the recouponing of CDS to 100bp or 500bp. This change achieves two things: enhances fungibility and liquidity for clients and solves the vexing risky annuity issue that has brought much pain to dealers throughout the years.

Why Recoupon CDS?
To illustrate the basic motivation for the recouponing change consider a reference entity that has one bond outstanding and no loans. Trading the credit of this company is pretty easy: you’ve got a single security with a fixed coupon and an observable market price.

Now imagine that CDS starts trading on the name. Each day the spread moves you’ve got a different tradable product out there whether at 100bps or 150bps or 500bps or even upfront + 500bps running. So if a dealer does 10 bond trades, he’s either paying or receiving the coupon on the bond so the trades net out, nice and simple. However, if the same dealer does 10 CDS trades, it will likely have 10 trades all with different coupons and hence with different time decay, convexity and duration profiles, making risk management more difficult. Here, by the way, we are not even considering potentially different restructuring clauses, lookback credit event effective dates, roll dates and accrual periods.

Why not simply unwind previous trades, rather than put on new trades? Well, unwinding previous trades essentially means trading in off-market CDS which, as first time CDS participants quickly find out, carries an extra bid/offer cost – in fact, when quoting a level many dealers will explicitly ask you whether it’s for a new trade or an unwind of an existing position. The other problem is that only clients (i.e. buyside firms) can unwind CDS with dealers, not the other way around. In other words, dealers cannot exactly call up a client and ask them to unwind CDS trades just because it suits the dealer’s book.

So, if dealers charge extra for unwinding existing CDS positions, why don’t clients just put on new trades? The quick answer is that the practice guarantees continuous growth of the CDS book which will significantly stretch risk management/systems resources of small funds. The extra complexity comes not only from booking the trades, but also from calculating daily exposure and managing collateral on the positions. Also, by doing new trades, rather than unwinding existing positions, a fund will add counterparty risk, which it may need to manage by buying protection which adds even more trades to the book.

Enhanced Fungibility
Moving CDS to fixed coupons will make CDS trades more fungible and increase liquidity by making all trades “on-market”. This is all well and good and ensures that clients are happy as they will no longer be ripped off trying to unwind existing positions with dealers or suffering operational burden from the explosion of the trading book or having to manage dealer counterparty risk. These are all solid reasons for the recouponing. However, I would argue that the biggest beneficiary of the recouponing will be dealers as the change will eliminate the dreaded risky annuity risk which has been the bane of CDS risk management for a long time. What is risky annuity risk?

Risky Annuity Risk
To illustrate risky annuity risk, consider the following. Let’s say a dealer bought protection on a name at 100bp. The name subsequently widens and the dealer does a new trade selling protection at 300bp. From the looks of it, the trader should be happy as he is now flat the name and has booked a profit of 200bp running. Assuming $50mm notionals on each leg and a risky duration of 4.5, the trader is up $4.5mm on the trade (a simple present value calculation of 200bp for 5 years) – off to the bar with the lads!

A month goes by and the trader is focused on other things. A headline flashes across his bloomberg screen – the company in question has just filed for bankruptcy. Given that he is “flat” the name, he shouldn’t care. Yet he does – in fact, he has just lost $4.5mm. The problem, of course, is that the 200bp annuity he is receiving is risky to the survival of the company. If the reference entity suffers a credit event, both CDS are triggered and the coupon streams go away.

This is why it isn’t always fun being the dealer and making bid/offer on CDS. Clients can come back to the dealer and unwind existing trades (if at a higher cost than new on-market trades). Dealers do not have this luxury – and their books are spider webs of risky annuities with very significant jump-to-default risks that are essentially unhedgeable. The heads of credit desks did not have a happy time having to explain to CEO’s why they periodically lost tens of millions of dollars on credits that they were flat or even short. CEO’s quickly got up to speed with the fact that you can be short delta but long jump-to-default risk.

In fact, this was such a pressing problem that several dealers have attempted to create products to manage this risk. One of these products was an Annuity CDS which essentially turned a risky annuity into an upfront payment. However, since these products would never be as liquid as standard CDS and that they essentially solved a problem for dealers without offering any particularly compelling features to clients, they failed to take off.

Recouponing CDS is the right, if belated, step in the right direction for the market which should make both the buy and sellside a touch happier in these otherwise difficult times.

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