What Does Credit Default Swap (CDS) Mean?

A swap designed to transfer the credit exposure of fixed income products between parties.

Investopedia explains Credit Default Swap (CDS)

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the
credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed
income security to the seller of the swap.

For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the
swap, should the bond default in its coupon payments

A swap is an agreement between two parties to exchange sequences of cash flows for a set period of
time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined
by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or
commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a
long position in one bond coupled with a short position in another bond. This article will discuss the two
most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.

The Swaps Market

Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments.
Instead, swaps are customized contracts that are traded in the over-the-counter(OTC) market between
private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals
ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty
defaulting on the swap. (For background reading, see Futures Fundamentals and Options Basics.)

The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their
relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives
Association reported that the swaps market had a total notional value of $865.6 billion. By mid-2006, this
figure exceeded $250 trillion, according to the Bank for International Settlements. That's more than
15 times the size of the U.S. public equities market.

Plain Vanilla Interest Rate Swap

The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees
to pay Party B a predetermined, fixed rate of interest on a notional principalon specific dates for a
specified period of time. Concurrently, Party B agrees to make payments based on a floating interest
rate to Party A on that same notional principal on the same specified dates for the same specified time
period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment
dates are called settlement dates, and the time between are called settlement periods. Because swaps
are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other
interval determined by the parties. (For related reading, see How do companies benefit from interest rate
and currency swaps?)

For example, on December 31, 2006, Company A and Company B enter into a five-year swap with the
following terms:
 • Company A pays Company B an amount equal to 6% per annum on a notional principal of $20
million.
• Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional
principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by
other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses
LIBOR as the base for the floating rate. For simplicity, let's assume the two parties exchange payments
annually on December 31, beginning in 2007 and concluding in 2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On December 31,
2006, one-year LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% +
1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the
beginning of the settlement period. Normally, swap contracts allow for payments to be netted against
each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays
nothing. At no point does the principal change hands, which is why it is referred to as a "notional" amount.
Figure 1 shows the cash flows between the parties, which occur annually (in this example). (To learn
more, read Corporate Use Of Derivatives For Hedging.)

Figure 1: Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency Swap

The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in
one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an
interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and
end of the swap. The two specified principal amounts are set so as to be approximately equal to one
another, given the exchange rate at the time the swap is initiated.

For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency
swap for $50 million. Let's assume the exchange rate at the time is $1.25 per euro (i.e., the dollar is worth
$0.80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D
pays ¬40 million. This satisfies each company's need for funds denominated in another currency (which is
the reason for the swap).

Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their
respective principal amounts. To keep things simple, let's say they make these payments annually,
beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay
interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay
interest in dollars, based on a dollar interest rate. For this example, let's say the agreed-upon dollar-
denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year,
Company C pays ¬40,000,000 * 3.50% = ¬1,400,000 to Company D. Company D will pay Company C
$50,000,000 * 8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments
against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is
$1.40 per euro, then Company C's payment equals $1,960,000, and Company D's payment would be
$4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 -
$1,960,000) to Company C.

Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-
exchange the original principal amounts. These principal payments are unaffected by exchange rates at
the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3

Who would use a swap?

The motivations for using swap contracts fall into two basic categories: commercial needs
and comparative advantage. The normal business operations of some firms lead to certain types of
interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a
floating rate of interest on deposits (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., assets).
This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a
fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-
rate assets, which would match up well with its floating-rate liabilities.

Some companies have a comparative advantage in acquiring certain types of financing. However, this
comparative advantage may not be for the type of financing desired. In this case, the company may
acquire the financing for which it has a comparative advantage, then use a swap to convert it to the
desired type of financing.

For example, consider a well-known U.S. firm that wants to expand its operations intoEurope, where it is
less well known. It will likely receive more favorable financing terms in theUS. By then using a currency
swap, the firm ends with the euros it needs to fund its expansion.

Exiting a Swap Agreement

Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This
is similar to an investor selling an exchange-traded futures or option contract before expiration. There are
four basic ways to do this.
1. Buy Out the Counterparty
Just like an option or futures contract, a swap has a calculable market value, so one party may
terminate the contract by paying the other this market value. However, this is not an automatic
 feature, so either it must be specified in the swaps contract in advance, or the party who wants
out must secure the counterparty's consent.

2. Enter an Offsetting Swap

For example, Company A from the interest rate swap example above could enter into a second
swap, this time receiving a fixed rate and paying a floating rate.

3. Sell the Swap to Someone Else

Because swaps have calculable value, one party may sell the contract to a third party. As with
Strategy 1, this requires the permission of the counterparty.

4. Use a Swaption
A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not
enter into, a potentially offsetting swap at the time they execute the original swap. This would
reduce some of the market risks associated with Strategy 2..
Conclusion
Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many
firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction
to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed
for further study. You now know the basics of this growing area and how swaps are one available avenue
that can give many firms the comparative advantage they are looking for.

by Michael McCaffrey (Contact Author | Biography)

Michael K. McCaffrey, MS, CFA, recently moved to Austin, Texas, to join a major mutual fund company
as a performance analyst. Previously, Mike was the senior investment analyst for Mercer Advisors - an
independent, fee-only registered investment advisor - managing $2.9 billion. Mike earned a Bachelor of
Science in economics from Texas Christian University and a Master of Science in finance from the
George Washington University. Mike also holds a Chartered Financial Analyst (CFA) designation and has
passed the first of two exams toward becoming a Chartered Alternative Investment Analyst (CAIA).

Credit default swaps (CDS) are the most widely used type of credit derivative and a powerful force in the
world markets. The first CDS contract was introduced by JP Morgan in 1997 and by mid-2007, the value
of the market had ballooned to an estimated $45 trillion, according to the International Swaps and
Derivatives Association - over twice the size of the U.S. stock market. Read on to find out how credit
default swaps work and the main uses for them.
How They Work
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market
bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance
because it provides the buyer of the contract, who often owns the underlying credit, with protection
against default, a credit rating downgrade, or another negative "credit event." The seller of the contract
assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee
similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is
important to note that the CDS contract is not actually tied to a bond, but instead references it. For this
reason, the bond involved in the transaction is called the "reference obligation." A contract can reference
a single credit, or multiple credits. (To learn more about bonds, see our tutorial Advanced Bond
Concepts.)

As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of
the transaction, when the reference entity (the issuer) has a negative credit event. When such an event
occurs, the party that sold the credit protection and who has assumed the credit risk may deliver either
the current cash value of the referenced bonds or the actual bonds to the protection buyer, depending on
the terms agreed upon at the onset of the contract. If there is no credit event, the seller of protection
receives the periodic fee from the buyer, and profits if the reference entity's debt remains good through
the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big
losses if a credit event occurs. (For related reading, see Corporate Bonds: An Introduction To Credit
Risk.)

Hedging and Speculation

CDS have the following two uses.
• A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan.
An individual or company that is exposed to a lot of credit risk can shift some of that risk by
buying protection in a CDS contract. This may be preferable to selling the security outright if the
investor wants to reduce exposure and not eliminate it, avoid taking a tax hit, or just eliminate
exposure for a certain period of time. (For more on hedging your investments, read Practical And
Affordable Hedging Strategiesand Corporate Use Of Derivatives For Hedging.)
• The second use is for speculators to "place their bets" about the credit quality of a particular
reference entity. With the value of the CDS market, larger than the bonds and loans that the
contracts reference, it is obvious that speculation has grown to be the most common function for
a CDS contract. CDS provide a very efficient way to take a view on the credit of a reference
entity. An investor with a positive view on the credit quality of a company can sell protection and
collect the payments that go along with it rather than spend a lot of money to load up on the
company's bonds. An investor with a negative view of the company's credit can buy protection for
a relatively small periodic fee and receive a big payoff if the company defaults on its bonds or has
some other credit event. A CDS can also serve as a way to access maturity exposures that would
otherwise be unavailable, access credit risk when the supply of bonds is limited, or invest in
foreign credits without currency risk. (For more, seeRisky Portfolio? Currencies Come To The
Rescue.)
An investor can actually replicate the exposure of a bond or portfolio of bonds using CDS. This can be
very helpful in a situation where one or several bonds are difficult to obtain in the open market. Using a
portfolio of CDS contracts, an investor can create a synthetic portfolio of bonds that has the same credit
exposure and payoffs.

Trading
While most of the discussion has been focused on holding a CDS contract to expiration, these contracts
are regularly traded. The value of a contract fluctuates based on the increasing or decreasing probability
that a reference entity will have a credit event. Increased probability of such an event would make the
contract worth more for the buyer of protection, and worth less for the seller. The opposite occurs if the
probability of a credit event decreases. A trader in the market might speculate that the credit quality of a
reference entity will deteriorate some time in the future and will buy protection for the very short term in
the hope of profiting from the transaction. An investor can exit a contract by selling his or her interest to
another party, offsetting the contract by entering another contract on the other side with another party, or
offsetting the terms with the original counterparty. Because CDSs are traded over the counter (OTC),
involve intricate knowledge of the market and the underlying assets and are valued using industry
computer programs, they are better suited for institutional rather than retail investors. (For more insight,
read Are Derivatives Safe For Retail Investors?)

Market Risks
The market for CDSs is OTC and unregulated, and the contracts often get traded so much that it is hard
to know who stands at each end of a transaction. There is the possibility that the risk buyer may not have
the financial strength to abide by the contract's provisions, making it difficult to value the contracts.
The leverage involved in many CDS transactions, and the possibility that a widespread downturn in the
market could cause massive defaults and challenge the ability of risk buyers to pay their obligations, adds
to the uncertainty.

Conclusion
Despite these concerns, credit default swaps have proved to be a useful portfolio management and
speculation tool, and are likely to remain an important and critical part of the financial markets.

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