Credit Default Swaps (CDS)

A CDS is an instrument/contract that provides protection against the default of a specific company or government.

There are three parties or elements in the contract:

• Protection buyer — the buyer of protection;
• Protection seller — the seller of protection;
• Reference entity — the company or government whose credit risk is covered by the contract.

The protection buyer makes periodic payments, known as the CDS spread. The protection seller assumes the obligation to compensate the loss if a default occurs.

The riskier the market considers the company to be, the higher the payment.

For example, suppose a bank has lent $100 million to a company.

The bank wants to keep the loan, but it does not want a possible default by the company to cause it a loss. It therefore buys five-year CDS protection under the following terms:

• CDS notional: $100 million;
• CDS spread: 0.90% per year;
• Payments: quarterly.

The bank’s annual payment will be:

100,000,000 * 90% = 900,000

The quarterly payment will be:

If the company does not default during the five-year period, the bank pays the premiums but receives no compensation.

This is similar to insurance: buying home insurance does not mean that a fire will necessarily occur, although a CDS is different from ordinary insurance.

What happens in the event of default?

Suppose the company defaults and the value of its bonds falls to only 35% of face value.

This means that, from the $100 million debt, the market expects only $35 million to be recovered.

As a result:

• the bank receives the remaining $35 million from the borrower or from the borrower’s assets;
• it receives $65 million from the CDS seller.

Why do banks buy CDS protection?

A CDS allows a bank to separate two decisions:

• whether it wants to lend to the client;
• whether it wants to bear the full credit risk of that loan.

The bank may want to maintain its relationship with the client.

The client may process payments through the bank, use bank guarantees, trade finance, or other banking services.

In such a case, selling the loan may not be attractive to the bank.

However, if the bank has accumulated excessive credit exposure to one borrower, sector, or country, it can buy a CDS and transfer part of that risk to another party.

A CDS can therefore be used:

• to reduce the risk of a specific borrower;
• to manage sector concentration;
• to diversify a credit portfolio;
• to limit a potentially large loss.

Who receives the risk?

The risk does not disappear.

If the company does not default, the protection seller receives periodic income.

If the company defaults, the protection seller may have to make a very large payment.

The position of a CDS seller is therefore somewhat similar to an insurance business.

Historically, banks have often been buyers of protection, while insurance companies have often been sellers of protection.

However, there is one important difference between a CDS and ordinary insurance.

To insure a house, you generally need to own the house.

To buy CDS protection, however, you do not need to own the relevant company’s bonds or loan.

An investor can buy CDS protection on a company even if the investor does not own any of that company’s debt.

In that case, the CDS is no longer used only for hedging.

It is often a bet on the deterioration of the company’s credit condition.

If the company’s risk increases, previously purchased protection becomes more valuable.

This can create a situation in which the total notional amount of CDS contracts written on one company is greater than the company’s total outstanding debt.

The CDS market therefore performs two functions at the same time:

• it transfers and distributes real credit risk;
• it creates an opportunity to speculate on credit risk.

Where does systemic risk arise?

By buying a CDS, a bank reduces its risk only if the CDS seller is able to pay when a default occurs.

If the protection seller has sold too much CDS protection and does not have sufficient capital, it may itself face financial difficulties.

In that case, the transfer of risk becomes illusory.

The bank may believe that its loan is hedged, but during a crisis it may discover that the CDS seller is also unable to pay.

The borrower’s credit risk is simply replaced by the counterparty risk of the CDS seller.

This was one of the major problems during the 2007–2008 global financial crisis, which began with widespread defaults on real estate-related loans.

Source:

John C. Hull, Options, Futures, and Other Derivatives.