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Equity default swaps - a new product in the market

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By Vinod Kothari

Equity default swaps use the credit default swap technology, but not to transfer credit risk - they transfer the risk of major diminution in the market value of shares. Like in case of credit default swaps, equity default swaps have also been linked to notes and taken into the capital market in form of "credit linked notes" - you may also call them equity linked notes.

Another interesting dimension in the equity default swap (EDS) application has been that CDOs have included equity default swaps in their overall portfolio - along with credit default swaps, total rate of return swaps, etc.

The usual modality of an EDS is to choose a trigger event, similar to credit events - typically a decline of 30% or more in the equity price of the reference entity from the effective date. The terms of settlement may be either physical delivery or cash settlement. And cash settlement might have a binary payout or the actual difference in valuation. In case of binary settlement, the payout can be based on an assumed recovery of 50%. Thus, if the market value falls by 30% or more, the protection buyer is paid to the extent of 50% by the protection seller. Note that neither the decline of 30% is sacrosanct, nor the recovery rate - for instance, the Zest CDO noted below uses a 70% decline as the trigger point.

While the determination of credit events in credit derivatives is less transparent, the trigger event in EDS is market information-based, and hence, is more transparent.

EDS and CDS

How do equity default swaps relate to credit derivatives? Credit derivatives are contracts relating to the general credit of the reference entity. The typical reference obligation is unsecured loans or bonds - which are technically triggered only after the equity is fully lost. On the contrary, EDS are latched to a certain percentage loss in equity value - therefore, the trigger events in EDS will occur much sooner than the credit event in CDS. However, both relate to the general credit of a reference entity.

EDS and equity puts:

How are EDS different from equity puts? In essence, even a credit default swap is a put, so is an equity default put. The only distinction possibly is the steepness of the decline in equity prices and the recovered amount.

Where does it come from?

Quite obviously, the trend towards exotic credit derivative products stems from the urge of portfolio managers to pick up yields and to introduce more product diversification.

Interestingly, rating agencies have rated CDOs which included equity default swaps. .

EDS activity:

The first notable transaction of CDO incorporating EDS was Moody's-rated Odysseus deal arranged by JP Morgan, which consisted of a portfolio of 100 reference entities, with 10% of these being EDS.

In Japan, in February 2004, Daiwa Securities SMBC took the EDS concept a step further when it launched the first publicly rated arbitrage CDO 100% collateralised by EDS. Zest Investments V issued ¥31.5 billion of notes in five different classes, backed by EDS on a portfolio of 30 quoted blue-chip corporates with an aggregate notional amount of ¥45 billion. Payment to the protection buyer will be triggered if the share price of any of the companies referenced in the EDS portfolio falls by more than 70% from its initial price and if the share price fails to recover to the initial level by December 2008.