Globally, the continued squeeze on credit-default spreads has made it increasingly difficult for banks to arrange synthetic CDO transactions which offer sufficient return to attract investors (particularly for the equity tranche) whilst allowing the swap counterparty to retain a sufficient yield. In Asia the slowdown has been more dramatic since the appetite for the more complex (but potentially higher yielding) structures and asset classes, such as CDOs of ABS and truly managed products, lags behind the European market.
In recent months, equity-default swaps (EDS) have emerged as a possible boost to the structured finance market--offering better returns to investors for a credit-style risk.
What Is An Equity-Default Swap?
EDS share some similarities with CDS, in that they are derivatives in which one party is buying protection against the risk of an event occurring to one or more designated companies during a defined period. In the case of an EDS, however, what is being hedged is not the risk of a credit event in relation to a Reference Entity (such as a failure to pay or bankruptcy) but the risk that the share price of a Reference Entity falls during the period by more than a set percentage (typically 70%). If the share price does fall in this way (a Knock-in Event), the Seller will have to pay a settlement amount to the Buyer. The amount payable may be either a fixed amount (often on the basis of a 50% loss of notional) or determined by reference to the final value of the reference share--if that final price is actually higher than the initial price or some other pre-determined level then the Seller may not have to make any payment at all.
The chart [below] illustrates how such an EDS will operate.
At the risk of removing all of the mystery, an equity-default swap is therefore really just a deeply out-of-the-money equity barrier put option. What distinguishes the EDS from the more usual equity put option is that the knock-in level is set so low (usually at 30% of the initial share price). At such a level there has been shown to be a close correlation between the probability of such a dramatic fall in a share price and the likelihood of a credit event occurring on the same reference entity. Credit ratings can therefore be used as indicators of the risk under an EDS.
As a result of this correlation, rating agencies are able to give a rating to the risk under an EDS, and it is this development which is one of the main factors spurring interest in this market. It means that banks can market these products to fixed income investors as alternatives to credit-default swaps, and can pitch both single name and portfolio trades to investors who have previously bought CLNs or CDOs. The other reason for the interest is that the spreads on EDS can be so much higher than the spread on a CDS on the same reference entity--in some cases 10 times higher or more.
In other words, an EDS investor is exposed to the same general type of risk as it faced under a CDS contract on the same reference entity, but can earn a much greater return.
Other attractive features of EDS are that they are very simple to understand, there is a great deal of market data which an investor can draw on to assess the level of risk (although admittedly relatively few banks quoting EDS pricing itself), there is a much wider universe of reference entities on which EDS contracts can be written and they are conceptually already familiar to equity traders.
Increased Risks Associated With
An Equity-Default Swap
Notwithstanding the correlation which rating agencies have identified, it would obviously be misleading to claim that the risk under an EDS is identical to that under a CDS. In return for the increased return, there is a much wider range of risks associated with an EDS--including general volatility in share prices (particularly where a Knock-in Event may be triggered by intra-day trading levels and general stock market turmoil) and the risk of correlation between share price movements for Reference Entities operating in the same country or industry sector. These could cause a sudden downturn in the share price of a company even in circumstances where the actual fundamentals of its business, and the risk of its default or bankruptcy, are unchanged.
The increased risk associated with an EDS compared to the equivalent CDS also appears to be reflected in the emerging rating agency criteria, which seem to anticipate a larger "first loss" piece on a portfolio EDS trade than the corresponding credit default CDO to achieve the same rating for the senior tranches.
Rating Agencies
All of the main international rating agencies are in the process of formulating their approach to rating EDS transactions, both in terms of their rating methodology (based on historical share price data and analysis of periods of extreme stock market volatility) and as to their documentation requirements. The availability of ratings can also be expected to attract investors to this type of product, mostly the fixed income investors who might previously have been unwilling or unable to take on equity risk.
Documentation Issues
EDS will be documented under either the 2002 or the 1996 ISDA Equity Derivatives Definitions. Whilst the 2002 Definitions are now the general standard in the market, there is a risk of mismatch as some banks continue to trade on the 1996 Definitions.
The Equity Definitions contain wider adjustment provisions and allow the calculation agent a greater degree of flexibility in making determinations than is the case for CDS contracts. The rating agencies have indicated that the scope of Calculation Agent discretion is an area of concern for them in reviewing EDS documents--there is likely to be pressure on the swap counterparty to rely on more objective criteria, particularly when valuing the shares in the event of market disruption. This may expose the swap counterparty to greater risk of a mismatch between its swap and its hedge, particularly if it is intending to hedge through actual holdings of the reference shares.
Parties will also need to consider carefully how to deal with extraordinary events (mergers, tender offers, nationalization, insolvency and delisting). The standard "cancellation and payment" approach on OTC contracts may not be appropriate on CDO-style transactions due to the impact on cash flows. One alternative may be to replace, in accordance with specified criteria, the affected Reference Entity.
The Market For EDS
Whilst several banks have been using EDS in smaller, private transactions, we have also seen the first public, rated CDO of EDS in the form of Daiwa Securities' Zest V transaction--a 100% EDS deal with no credit default swaps at all. In Zest V investors taking risk on a portfolio of 30 EDS transactions, each referencing a Japanese blue chip corporate. The deal consisted of some JPY31.5 billion of Notes in five classes, three of which were rated by Moody's Investors Service. This contrasts with "hybrid" transactions, such as JPMorgan's Odysseus, in which a CDO is structured with a mix of CDS and EDS contracts (with EDS often accounting for only 10% of the notional value).
"Hybrid" transactions can also be structured where an investor is exposed to the risk of both credit and Knock-in Events on the same reference entities. These throw up some interesting structuring and documentation issues. Parties must consider how they want to use the Credit Definitions and the Equity Definitions. For instance, if there is a merger event the successor Reference Entity may be different under the CDS and the EDS limbs of the transaction. Also, what happens if both a credit event and a Knock-in Event occur? Will the protection buyer be able to wait before electing which event to rely on? Will that election affect the settlement amount payable and what, if anything, will be valued?
As more banks begin quoting pricing for EDS contracts, and liquidity increases, there should be scope for arbitrage plays between the varying risk profile and spreads available on CDS and EDS. We may see investors wishing to sell EDS protection and buy CDS protection on the same name, to exploit the yield differential, with the consolation of being able to offset any losses following a Knock-in Event under the EDS contract by the (hopefully) higher close out value of the CDS, assuming that credit spreads on the reference entity will widen significantly as its share price moves near the Knock-in level. We may also see pressure from CDO managers to buy and sell EDS protection in managing CDO portfolios, again to exploit the higher yields available without changing the overall type of risk for investors.
Conclusion
Equity-default swaps appear to offer a welcome means of improving yield on CDOs and to introduce a wider universe of reference entities to investors. The real growth in this market is likely to depend on the speed with which fixed income investors become confident with the correlation between EDS and CDS, and are willing to take on EDS risk as part of their investments. The rating agencies will also have a role to play, as they have been criticized for overly conservative rating criteria, with some market commentators arguing that, by placing too much emphasis on stock market volatility over recent years, the agencies are requiring levels of subordination which can make rated EDS transactions uneconomic. Banks will also need to take care in pitching these transactions to investors--the risks may be of a similar type, but the range of factors which could impact EDS and the actual probability of loss may well be higher than on a corresponding CDS.
Paul Cluley is a partner in the Tokyo office of Allen & Overy, and led the team which worked on the Zest V transaction, which was the first CDO of equity default swaps.
