Credit Default Swaps (CDS) for Non-Financial Firms — Basic Introduction
This article series will be about credit default swap premium calculation for Turkish BIST30 non-financial firms. First part will be general introduction of the concept, second part about mathematical background and third part about detailed calculations for specific firms.
Proper pricing of the financial instruments have an overbearing importance on the health and vitality of financial markets. For an investor, who buys a stock of a company, needs to know the default probability of the firm in the period he/she plans to hold the stock. For a bank, which gives loans the company, needs to know premium on the interest rate to be charged so that it can buy an insurance product that protects it from the default of the company. As these products may not be available for public or may be derived from financial firms that charge substantial fees, it is very important to understand the pricing of these products for all players who trade stocks of companies with financial liabilities or finance those companies with loans.
In 1974, Richard Merton proposed a model where a company’s equity is an option on the assets of the company. By using Black-Scholes formula for option pricing, we may calculate the price for this option. Before going into details of mathematics, I will try to explain the concepts in two parts;
When a company (for simplicity, a public non-financial company), gets a loan , that debt becomes risky by definition. If the company’s market value goes below the debt amount, stock holders my receive nothing.
Let’s give a simple example with a company having debt of 70 units. Equity value of the company is assets minus debt of the company. Let’s put two charts showing equity (E) and debt (D) with respect to different asset values (A). If value of the assets of the company goes below 70, equity is zero as there is nothing left after payment of debt to common stockholders. Equity is positive only after assets reach above 70. On the other hand, if assets go below 70, debt that can be paid to creditors will decrease; only after assets go above 70, debt can be paid in full.
Now, second graph is kind of curious as we can write it down as sum of two items: sum of riskless debt and a short put option on the debt of the company.
What is a put option? A brief definition of a put option will be helpful for non-financial reader. A long put option allows the buyer to sell a security at a determined price. On the other hand, a short put option seller agrees to buy the underlying security at that determined price.
Why is this put option important?
It’s important as it is the sole difference between the risk free loan rate(treasury) and actual rate that investors ask for underlying debt. It’s the premium for buying this debt instead of a risk free loan. It is Credit Default Swap rate for that security.
If we know volatility of the assets of the company, the question would be a simple calculation for an option with Black Scholes formula. However, while stock price volatility for a public company is easily observable, asset values are, unfortunately, not.
Why?
Because value of assets are recorded with historic values and by definition static in company books. Therefore, company financials are useless for derivation of volatility. Many few of assets are traded publicly, current market prices and hence volatility are observable only for a small portion of company assets.
Then? Let’s discuss this subject in the next article.
