Credit Default Swaps (CDS)

Credit default swaps, the most popular form of credit derivative, are used to either hedge credit risk or to profit from it. Other credit derivatives include the total return swap and the credit-linked note. A credit default swap (CDS) is a contract where the buyer is entitled to payment from the seller of the CDS if there is a default by a particular company. The price of a CDS for a particular company is often used to measure the creditworthiness of a company, since the price of the CDS will vary quickly in response to the market's assessment of the company's creditworthiness; by contrast, changes in credit ratings issued by credit rating companies, such as Moody's or Standard & Poor's, can take weeks or months. Defaults are the major form of credit event covered by CDS contracts. Banks are the biggest buyers; insurance companies are the biggest sellers.

The company for which credit protection is bought is called the reference entity. A single-name CDS is one that covers a debt security issued by a single reference entity, typically a corporation or a sovereign issuer. A portfolio CDS covers credit events by more than one reference entity.

When a credit event happens to the reference entity, the CDS seller is obligated to buy the defaulted bonds for their face value from the CDS buyer. Typical credit events defined in a CDS contract include:

Note that credit default swaps do not protect against interest rate changes, even if those changes are the result of a decrease in the creditworthiness of the issuer. Only if the credit event happens that is covered by the CDS contract will the CDS holder be compensated for the event.

The notional principal is the maximum amount payable by the CDS seller for a credit event.

The CDS buyer pays the seller a periodic premium—quarterly, semiannually, or annually—that covers the period previous to the payment until the contract ends, typically 5 years, or until a credit event happens, whichever comes first. The amount of the premium is specified as basis points of the notional principal.

1 Basis Point = .01%

For instance, a payment of 100 basis points per year on a $100,000,000 notional principal would amount to a payment of or 1%, or $1,000,000, every year from the buyer to the seller while the CDS is in force. The percentage of the notional principal paid per year–even if the premiums are paid quarterly or semiannually—as a premium is the CDS spread. So if a CDS buyer is paying 50 basis points quarterly, then the CDS spread is 200 basis points, or 2%, of the notional principal.

The contract is settled by the seller paying cash to the buyer of the CDS in the amount of the default. If the contract stipulates a cash settlement, then the buyer just receives the cash and the contract is terminated. If the contract provides for the delivery of the defaulted bonds, then the buyer must convey the bonds to the seller for the cash.

Several large banks serve as market makers in the CDS market, publishing bid and offer prices. Just as with market makers of other securities, the bid price is the amount that the market maker is willing to purchase CDS protection and the offer price is the amount the market maker is willing to sell such protection. When the CDS is first created, the value of the CDS in the secondary market is zero, assuming that the principals negotiated their contract skillfully. The CDS acquires market value as the economy changes, and as the fortunes of both the reference entity and the CDS seller change.

Because the premium is paid in arrears, any premium that would have been due is prorated from the last period to the time of default and subtracted from the cash payment.

There are other means of mitigating risk, such as loan syndication, borrower diversification, third-party loan guarantees, and letters of credit, but the main benefit of credit derivatives is that credit risk can be bought and sold — just like stocks — in a market. So speculators, market makers, and arbitrageurs can also benefit from credit derivatives, even without any primary exposure to the issuer, which also narrows the spread of bid/ask prices.

CDS Spreads and Bond Yields

A CDS reduces the risk of loss from a credit event for holders of bonds issued by the reference entity significantly, because in order for the CDS holder to lose, both the reference entity and the CDS seller would have to go bankrupt—considered unlikely previous to the credit crisis of 2008, so the risk was considered nearly zero. Hence, the combination of purchasing the bond of the reference entity and buying CDS protection for that bond creates a nearly risk-free synthetic asset, and so the price of a CDS spread should be comparable to the bond yield of the reference entity minus the risk-free yield of a Treasury security with the same maturity.

CDS Spread = n-Year Bond Yield – n-Year Risk-free Yield

If the CDS is significantly different from this, excluding trading and liquidity costs, then nearly risk-free profits can be earned from arbitrage. If the CDS spread is greater, then the investor can earn a higher risk-free return rate by buying the bond and buying CDS protection. Of course, this synthesis is not as risk-free as a Treasury, since there is a chance that both the bond issuer and the CDS issuer will default. If the CDS spread is less, then the investor can profit by selling short the bond and selling CDS protection.

CDS Settlement—Cheapest to Deliver Option

When a bond defaults, the buyer of the CDS is entitled to the notional principal minus the recovery rate of the bond. The recovery rate of the bond is considered its value immediately after default.

CDS Payoff = Notional Principal × (1 – Recover Rate)

So if the recovery rate on $1,000,000 worth of bonds is 75%, then the CDS  payoff = $1,000,000 ×  (1 – .75) = $250,000.

Credit swaps can be cash-settled, where the CDS seller pays the CDS buyer the amount by which the bonds or other referenced financial instrument devalues because of the credit event. In a physical settlement, the seller buys the bonds from the buyer for their par value.

With a physical settlement, most CDS contracts allow the buyer to select from a number of different bonds that have defaulted to deliver to the CDS seller, although they must have the same seniority. Even with the same seniority, however, bond prices may differ because of accrued interest or because some bonds may have a higher value in a reorganization. Bonds with a higher accrued interest have greater value than others in the same class. In most cases, the CDS buyer has the option of delivering the cheapest-to-deliver bond to the CDS seller. In the case of a cash settlement, the calculation agent will use the cheapest-to-deliver price to determine the cash settlement.

Diagram illustrating the cash flow for a credit default swap.

Some CDSs are binary credit default swaps that pay a fixed dollar amount in the case of default. They are described as binary because they either pay the fixed dollar amount or nothing at all. Thus, these swaps are cash-settled, so the recovery rate or the cheapest to deliver bond prices are not relevant.

Credit Default Swap Risks

The buyer of CDS protection bears most of the risk of the swap, because the main risk of credit default swaps is that the seller of protection is unable to pay in the case of a credit event that is covered by the CDS contract. In other words, while a credit default swap is supposed to protect the buyer of the CDS from credit risk of the reference entity, it does not protect against the credit risk of the CDS seller! Furthermore, if the CDS seller defaults, then the CDS buyer suffers losses from both the referenced credit event of the reference entity and from the loss of premiums paid to the CDS seller.

Hence, a CDS seller must have top credit, and if the credit rating of the CDS seller declines, most CDS contracts require that the CDS seller post more collateral to protect the CDS buyer. This is what precipitated American International Group's (AIG) free fall to inevitable bankruptcy before the United States government bailed it out with an $85 billion loan.

It seems that AIG had a small department that sold only CDS protection. Evidently, the traders in this department considered the premiums to be virtually free money, since they did not hedge their own risk, and they sold a lot more protection than what they could actually cover. Worse still, most of the protection was for mortgaged-backed securities based on subprime mortgages that started defaulting in significant numbers in 2008, causing the credit rating agencies to downgrade the credit rating of AIG, which, by force of contract, required AIG to post more collateral for its credit default swaps. Alas, it become acutely obviously that AIG didn't really have the capital to cover all of its CDS buyers. Because of the danger of credit contagion, which is when the default of 1 company causes a cascade of defaults to other companies, the United States government bailed out AIG to prevent more defaults, and more credit contagion from undermining the financial institutions of the United States.

Credit contagion is a significant risk to any economy of credit default swaps, since by their very nature, a failure in any part of the chain can cause more failures of other institutions with their own cascading effects.

Credit Default Swap Statistics

Statistics for credit default swaps are often reported in the press, but most of these reports are based on surveys. The problem with surveys is that the reported statistics are often inflated because they are reporting both sides of a single contract as though they were separate contracts, which doubles the reported amount above the actual notional principal amount. For instance, if a survey contacted 2 CDS dealers that reported a $1 billion trade, with one dealer being the seller and the other dealer being the buyer of the contract, then the survey would report a $2 billion notional principal even though it is actually only $1 billion.

The Deposit Trust and Clearing Corporation (DTCC) has established its automated Trade Information Warehouse as an electronic central registry for credit default swaps. According to DTCC, all of the major credit default swap dealers have registered most of their contracts that are outstanding in the Warehouse. The DTCC has reported that as of October 9, 2008, there was $34.8 trillion (in USD equivalents) of credit default swaps outstanding (different sides of the same trade were not counted twice), down from the $44 trillion registered in April, 2008. Although there was much reporting in the press that much of the financial crisis arose because of the credit default swaps written to protect mortgages, the DTCC reports that less than 1% of all outstanding credit default swaps were for residential mortgage-backed securities and the volume of CDSs for mortgage-related index products was also small. The DTCC also reports that the net transfer of payments from the sellers of protection of Lehman Brothers, which has declared bankruptcy, to the buyers of that protection was expected to be $6 billion. (Statistics source: DTCC Addresses Misconceptions About the Credit Default Swap Market)