Credit Default Swap (CDS

• A credit default swap (CDS) is a kind of insurance against credit risk.

o It is a privately negotiated bilateral contract.

• CDS buyer, long protection, pays a fixed fee or premium to the CDS seller, short
protection, for a period of time.
o If a pre-specified “credit event” occurs, the CDS short pays compensation to
the CDS long.

• The “credit event” can take on various forms including:

o Bankruptcy of a company, called the “reference entity.”
o Default of a bond or other debt issued by the reference entity.

• If no “credit event” occurs during the term of the swap, the CDS long continues to
pay the premium until maturity.

• If a “credit event” occurs at some point before the contract’s maturity, the CDS short
owes a payment to the CDS long, thus insulating the protection buyer “long” from a
financial loss.

• CDS can be used to gain exposure to credit risk.

o The risk profile of a CDS is similar to a corporate bond of the reference entity,
but there are several differences.
ƒ A CDS does not require an initial funding, which allows leveraged
positions.
ƒ A CDS transaction can be entered where a cash bond of the reference
entity of a particular maturity is not available.
ƒ By entering a CDS as a long position “protection buyer” you can
create a short position in the reference credit.

• Players in the CDS market:

o Commercial banks.
ƒ Commercial banks grant credit and are exposed to credit risk. Buying
protection through a CDS transfers their credit risk without having to
remove the assets from their balance sheet or involving borrowers.
o Insurance companies.
ƒ Increasing presence primarily on the short side as sellers of protection.
ƒ In 2003 insurance companies had global exposure of $137 billion.
o Financial guarantors.
ƒ Also big sellers of protection. Net sold position in 2003 of $166
billion.
 o Hedge funds.
ƒ Rumored to be active in the CDS market, but they are secretive and
not reported on any survey’s radar screen.

o Net positions of major players in the CDO market as of the end of 2003.

200

150

100

50

0
"Global Banks' Insurers Total' Insurers: Life, Health, Insurers: Reinsurance' Financial Gurantors' Hedge Funds'
P&C'
-50

-100

-150

-200

-250

• Mechanics of a CDS.
o In a credit default swap, the buyer and the seller of protection enter into a
contract where the protection buyer pays a fixed premium for protection
against a certain “credit event” such as a bankruptcy of the reference entity, or
a default of a debt issued by the reference entity.
o Usually there is no exchange of money when the two parties enter into the
contract.
ƒ They make payments during the term of the contract, thus explaining
the term credit default “swap.”

• CDS spreads.
o The spread is the premium paid by the protection buyer “long” to the seller
“short”.
o The spread is often quoted in basis points per annum of the contract’s notional
value and is usually paid quarterly.
o Note that CDS spreads are the annual price of protection quoted in bps of
notional value, and not based on any risk-free bond or any benchmark interest
rates.
• CDS are a form of put option.
o The protection buyer “long the put” can exercise the put when a credit event
occurs.
ƒ In the case of physical delivery the bond is put to the protection
provider in exchange for the par value.
ƒ In the case of cash settlement the protection seller reimburses the
protection buyer for the difference between the bond’s par and
recovery value.
o The CDS spread can be viewed as a premium on the put option, where
payment of the premium is spread over the term of the contract.
ƒ Example: The 5-year credit default swap for Ford was quoted around
160bps on April 27, 2004.
• This means that if you want to buy the 5-year protection for a
$10 million exposure to Ford credit, you would pay 40bps or
$40,000 every quarter as an insurance premium for the
protection you receive.

• Contract Size and Maturity

o No specific limits on size or maturity but most contracts fall between $10
million and $20 million in notional amount.
o Maturity ranges from one to ten years, with 5-year maturity being the most
common tenor.

• Trigger Events
o Bankruptcy
ƒ The reference entity becomes insolvent or unable to pay its debt.
o Failure to Pay
ƒ Occurs when the reference entity, after a certain grace period, fails to
make payment of principal or interest.
o Restructuring
ƒ A change in the terms of the debt obligations that is adverse to the
creditors.
• Pricing
o Early pricing of CDS was more art than science.
o Current pricing is more quantitatively based.
ƒ Parameters include
1. Probability of default (PD)
2. Recovery rate (1-LGD)
3. Some consideration for liquidity, regulatory, and market
sentiment about the credit.
o In theory, CDS spreads should be closely related to bond yield spreads, or
excess yields to risk-free government bonds.
ƒ Relationship between CDS and bonds.
1. Form a portfolio consisting of
a. Short the a CDS on Company A
b. Long a risk-free bond
2. Buy a corporate bond issued by Company A with notional
value $100
ƒ The above investments provide identical returns implying that the
CDS spread should equal the corporate bond spread.
• No default occurs.
o Portfolio 1 :
• CDS expires unexercised
• Risk-free bond pays $100
o Portfolio 2:
• Corporate bond pays $100
• Default occurs
o Portfolio 1:
• CDS put feature is exercised generating an
outflow of $100*LGD
• Risk-free bond pays $100
• Net cash inflow is $100*(1-LGD)
o Portfolio 2:
• Corporate bond defaults paying $100*(1-LGD)
• Accordingly, the CDS and the corporate bond should be traded
at the same spread level.
• In pricing a CDS, one must know, or make assumptions about:
o Probability of default over the term of the swap
o Loss given default
o Discount factors (yield curve).
o A typical CDS contract specifies two potential cash flow streams:
ƒ A fixed leg.
• On the fixed leg side, the buyer of protection “long” makes a
series of fixed, periodic payments of CDS premium until the
maturity, or until the reference credit defaults.
ƒ A contingent leg.
• On the contingent leg side, the protection seller “short” makes
one payment only if the reference credit defaults.
 • Amount of contingent payment is usually the notional amount
multiplied by LGD.
ƒ The value of a CDS contract to the protection buyer at any given point
of time is the difference between the present value of the contingent
leg and fixed legs.
Value of CDS (to protection buyer ) = PV [Contingent leg ] − PV [Fixed ( premium ) leg ]

• In order to calculate these values, you need information about

the default probability (credit curve) or the reference credit, the
loss-given-default, and risk-free discount factors (i.e. yield
curve).
• A less obvious factor is counterparty risk
• Pricing example
o See excel spreadsheet “Pricing CDS”
• Default
o The first step taken after a credit event occurs is a delivery of a “Credit Event
Notice,” either by the protection buyer or the seller.
o Compensation paid by the protection seller to the protection buyer is spelled
out in the agreement and will be via either
ƒ Physical settlement
• In a physical settlement, the protection seller buys the
distressed loan or bond from the protection buyer at par.
• The bond or loan purchased by the protection seller is called
the “deliverable obligation.”
• Physical settlement is the most common form of settlement in
the CDS market, and normally takes place within 30 days after
the credit event.
ƒ Cash settlement
• The payment from the protection seller to the protection buyer
is determined as the difference between the notional of the
CDS and the final value of the reference obligation for the
same notional.
• Cash settlement is less common because obtaining quotes for
the distressed reference credit often turns out to be difficult.
• Cash settlement typically occurs no later than five business
days after the credit event.
ƒ Credit Events
• Bankruptcy
o A bankruptcy is deemed to have occurred only if it
results in the default of the reference entity’s
obligations.
o A written admission of a company’s inability to pay its
debt must be made in a judicial, regulatory, or
administrative filing.
• Restructuring
o No Restructuring
• This option excludes restructuring altogether
from the contract, eliminating the possibility
that the protection buyer suffers a “soft” credit
event that does not necessarily result in losses to
the protection buyer.
o Full Restructuring
• This allows the protection buyer to deliver
bonds of any maturity after the restructuring of
debt in any form occurs.
o Modified Restructuring
• This has become common practice in North
America.
• It limits deliverable obligations to bonds with
maturity of less than 30 months after
restructuring.
o Modified Modified Restructuring
• This resulted from the criticism of the modified
restructuring that it was too strict with respect to
deliverable obligations.
• Under this arrangement, which is more popular
in Europe, deliverable obligations can be
maturing in up to 60 months after a
restructuring.
• Definitions of “Deliverable Obligations”
o The protection buyer is required to send notice of
physical settlement (NOPS), indicating exactly what
obligation is going to be delivered.
o In a physical delivery, the buyer of protection can
choose, within certain limits, what obligation to deliver.
• This allows the buyer to deliver an obligation
that is “cheapest to deliver.”
o In general, the buyer can deliver the following
obligations after a credit event:
• Direct obligations of the reference entity
• Obligations of a subsidiary of the reference
entity. The reference entity must own 50% or
more of the subsidiary’s voting stock.
• Obligations of a third party guaranteed by the
reference entity.
• Summary
o The risk profile of a CDS is very similar to that of corporate bonds.
o A plain vanilla CDS, unlike a corporate bond, does not require an initial
funding and is sometimes called “unfunded.”
o A CDS transaction can be entered where a cash bond of a particular reference
entity and/or a particular maturity is not available.
o Buying credit protection via CDS can allow the creation of a “short” position
in the reference credit
o Another application of CDS is a securitization product called synthetic
collateralized debt obligations (CDO).
ƒ While so-called cash CDOs involve a pool of corporate bonds or
structured finance assets, synthetic CDOs are formed from a large pool
of CDSs.
• Synthetic CDOs have become very popular in recent years,
especially in Europe where over 90% of deals are synthetic.
• In the U.S., Synthetic deals account for one third of all
arbitrage CDOs.
• Synthetic CDOs allow a much more flexible structure than
cash CDOs thanks to the unique characteristics of CDSs.