Credit Default Swap (CDS)

What is a credit default swap (CDS)?

A credit default swap (CDS) is a type of credit derivative enabling investors to swap or transfer their credit risk with another party, known as the protection seller. By purchasing a CDS, the protection buyer can mitigate the risk of default by having the protection seller agree to compensate them in case the borrower, who is the reference entity, fails to repay its debt obligations. This financial instrument serves as an insurance contract in the credit market, particularly for corporate bonds, government agency debt, or even emerging market bonds.

In a CDS contract, the protection buyer makes periodic premium payments to the protection seller, similar to insurance policy premiums. The CDS can be settled through physical settlement, where the protection seller delivers the underlying debt instrument to the protection buyer upon a credit event occurrence, or through cash settlement, where a cash payment is made to the protection buyer instead.

CDS transactions are widely used by banks, financial institutions, and investors to hedge credit exposure and manage risk. This played a significant role during events like the European sovereign debt crisis and the global financial crisis, where banks like Lehman Brothers faced insolvency.

The value of a CDS is influenced by various factors, including credit spreads, interest rates, credit quality of the reference entity, and the recovery rate in case of default. Market participants use CDS spreads as an indicator of credit risk, and the CDS price is determined by market demand and supply dynamics.

What are the characteristics of credit default swaps?

• Reference Obligation. The reference obligation refers to a specific bond or loan issued by the reference entity, forming the basis for the Credit Default Swap (CDS). Typically, a senior unsecured bond is used as a reference obligation.

• Notional Amount. The notional amount represents the sum payable by the CDS seller in case a credit event is triggered. It serves as a reference value for calculating potential payouts.

• CDS Spread. The CDS spread denotes the periodic premium paid by the CDS protection buyer to the seller.

• Maturity. The maturity is signifies the expiration date of the CDS contract, after which the terms of the agreement are no longer in effect.

• Upfront Premium. The upfront premium is the difference between the standardized coupon rate and the credit spread, and it is paid initially by one party. This amount accounts for the discrepancy between the present value of the credit spread and the standard rate.

How does credit default swaps work?

A credit default swap (CDS) is a financial contract designed to transfer the credit risk associated with fixed-income products, such as bonds or securitized debt, representing derivatives of loans sold to investors.

For instance, a scenario where a company sells a bond with a face value of $100 and a 10-year maturity to an investor, the company commits to repay the $100 at the bond’s maturity along with regular interest payments during its lifespan.

However, since the debt issuer cannot guarantee repayment, the investor assumes the risk. To mitigate this risk, the debt buyer can opt to purchase a CDS to shift the responsibility to another investor, known as the CDS seller, who agrees to compensate them in case of a negative credit event, such as borrower’s defaults.

Debt securities often have longer maturity terms, making it challenging for investors to assess the investment risk accurately. For example, mortgages may have terms extending up to 30 years, and it becomes uncertain whether the borrower can sustain payments over such an extended period.

The credit default swap market involves financial instruments that facilitate hedging risk and managing credit exposure. In CDS contracts, the buyer makes periodic payments to the CDS seller, usually in quarterly instalments. The CDS spread, determined by market demand and supply, reflects the credit spread and influences the CDS price and market value.

Credit default swaps became well-known to the general public during the global financial crisis, since they played a significant hedging role, with systemic investment banks like Lehman Brothers facing insolvency.

JP Morgan and other financial institutions are active players in the credit default swap market. Regulatory capital requirements may impact the use of CDSs for risk management purposes.

Advantages and disadvantages of credit default swaps

Advantages

• Risk Reduction for Lenders. CDSs can be acquired by lenders as a form of insurance, providing protection to the lender while transferring the risk to the issuer.

• No Need for Underlying Assets. Purchasers of CDSs are not obligated to buy the underlying fixed-income assets associated with the swap.

• Risk Diversification for Sellers. CDSs enable the transfer of default risk to the issuer, and sellers can further diversify their risk by selling multiple swaps.

Disadvantages

• False Sense of Security. Investors and lenders may develop a misguided belief that their investments carry no risk due to the protection provided by CDSs.

• Over-the-Counter Trading. CDSs, though risk-reducing, are traded over-the-counter, which exposes them to additional risks inherent in such markets.

• Inherited Substantial Risks. CDS sellers take on the risk of the borrower defaulting, potentially leading to significant losses.

What is an example of a credit default swap?

Credit default swaps serve various purposes and can be used in different ways:

• Speculation. CDSs, being traded instruments, possess fluctuating market values that present opportunities for CDS traders to make profits. Investors engage in buying and selling CDSs from one-another, aiming to capitalize on the price differences.

• Hedging. A credit default swap inherently serves as a hedging tool. For instance, a bank may acquire a CDS to hedge against the risk of borrower default. Similarly, insurance companies, pension funds, and other holders of securities can purchase CDSs as a means to hedge their credit risks.

• Arbitrage. Arbitrage involves purchasing a security in one market and selling it in another where the price is higher. CDSs can be utilized in arbitrage scenarios. An investor can purchase a bond in one market and simultaneously acquire a CDS on the same reference entity in the CDS market. This allows them to profit from potential price discrepancies between the two markets.

How did CDSs contribute to the 2008 financial crisis?

During the credit crisis that eventually led to the Great Recession, credit default swaps (CDSs) played a pivotal role. American International Group (AIG), Bear Sterns, and Lehman Brothers issued CDSs to investors as a means of safeguarding against losses in case mortgage-backed securities (MBS) defaulted.

Mortgage-backed securities involve bundling mortgages together and offering them as shares. The CDSs served as insurance against mortgage defaults, leading investors to believe that they had effectively mitigated the risk of losses if the worst-case scenario unfolded.

As housing prices continued to rise, investment banks and real estate investors granted mortgages to nearly anyone who applied, generating significant returns. CDSs enabled investment banks to create synthetic collateralized debt obligation (CDO) instruments, essentially betting on the prices of securitized mortgages.

The entwinement of investment banks in global markets made their insolvency ripple across the world, triggering the 2007-2008 financial crisis. Many investment banks had issued MBSs, CDSs, and CDOs, essentially betting on the performance of their own mortgage security derivatives. However, when housing prices collapsed, these major players found themselves unable to fulfill all their obligations due to owing each other and investors more money than they had available.

CDSs and European sovereign debt crisis

During the European sovereign debt crisis (2009-2012), credit default swaps (CDSs) saw extensive use. For instance, investors acquired Greece’s sovereign debt through sovereign bonds to support the country’s fundraising efforts. Additionally, they bought CDSs as a safeguard to preserve their capital in the event of a default by the country.

The crisis also impacted Portugal, Ireland, Italy, Cyprus, and Spain, leading them to the brink of financial collapse during that period.