What is a CDS?

Definition:- A swap designed to transfer the credit exposure

of fixed income products between parties.
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.
 Uses of CDS
• Credit default swaps are mainly used by investors for
a) Speculation and
b) hedging
 Speculation

• A an investor might speculate on an entity's credit quality, since generally

CDS spreads will increase as credit-worthiness declines, and decline as
credit-worthiness increases. The investor might therefore buy CDS protection
on a company to speculate that it is about to default. Alternatively, the
investor might sell protection if it thinks that the company's creditworthiness
might improve.

• The investor selling the CDS is viewed as being “long” on the CDS and the
credit, as if the investor owned the bond. In contrast, the investor who
bought protection is “short” on the CDS and the underlying credit.

• Credit default swaps opened up important new avenues to speculators.

Investors could go long on a bond without any upfront cost of buying a bond;
all the investor need do was promise to pay in the event of default.

• Because the speculator in either case does not own the bond, its position is
said to be a synthetic long or short position.
 Illustration
• For example, a hedge fund believes that Risky Corp will soon
default on its debt. Therefore, it buys $10 million worth of
CDS protection for two years from AAA-Bank, with Risky Corp
as the reference entity, at a spread of 500 basis points (=5%)
per annum.
• Now, the following two possibilities arise:
A. If Risky Corp does indeed default after, say, one year, then the hedge
fund will have paid $500,000 to AAA-Bank, but will then receive
$10 million (assuming zero recovery rate, and that AAA-Bank has the
liquidity to cover the loss), thereby making a profit. AAA-Bank, and its
investors, will incur a $9.5 million loss minus recovery unless the bank
has somehow offset the position before the default.
B. However, if Risky Corp does not default, then the CDS contract will run
for two years, and the hedge fund will have ended up paying $1 million,
without any return, thereby making a loss. AAA-Bank, by selling
protection, has made $1 million without any upfront investment.
(contd.)
• Note that there is a third possibility in the above scenario; the hedge fund could
decide to liquidate its position after a certain period of time in an attempt to realise
its gains or losses. For example:

a) After 1 year, the market now considers Risky Corp more likely to default, so its CDS
spread has widened from 500 to 1500 basis points. The hedge fund may choose to
sell $10 million worth of protection for 1 year to AAA-Bank at this higher rate.
Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million
= $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a total profit
of $500,000.

b) In another scenario, after one year the market now considers Risky much less likely
to default, so its CDS spread has tightened from 500 to 250 basis points. Again, the
hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-
Bank at this lower spread. Therefore over the two years the hedge fund will pay the
bank 2 * 5% * $10 million = $1 million, but will receive 1 * 2.5% * $10 million =
$250,000, giving a total loss of $750,000. This loss is smaller than the $1 million loss
that would have occurred if the second transaction had not been entered into.
 Speculation using Naked credit default swaps
• In the examples above, the hedge fund did not own debt of Risky Corp. A CDS in
which the buyer does not own the underlying debt is referred to as a naked credit
default swap, estimated to be up to 80% of the credit default swap market.

• There is currently a debate in the United States and Europe about whether
speculative uses of credit default swaps should be banned.

• Critics assert that naked CDS should be banned, comparing them to buying fire
insurance on your neighbour's house, which creates a huge incentive for arson.

• Analogizing to the concept of insurable interest, critics say you should not be able
to buy a CDS—insurance against default—when you do not own the bond.

• Because naked credit default swaps are synthetic, there is no limit to how many
can be sold. The gross amount of CDS far exceeds all “real” corporate bonds and
loans outstanding. As a result, the risk of default is magnified leading to concerns
about systemic risk.
(contd.)
• Proponents of naked credit default swaps say that short
selling in various forms, whether credit default swaps, options
or futures, has the beneficial effect of increasing liquidity in
the marketplace. That benefits hedging activities.
• Without speculators buying and selling naked CDS, banks
wanting to hedge might not find a ready seller of protection.
• Speculators also create a more competitive marketplace,
keeping prices down for hedgers.
• A robust market in credit default swaps can also serve as a
barometer to regulators and investors about the credit health
of a company or country.
 Hedging
• Credit default swaps are often used to manage the risk of default which arises from holding
debt. A bank, for example, may hedge its risk that a borrower may default on a loan by
entering into a CDS contract as the buyer of protection. If the loan goes into default, the
proceeds from the CDS contract will cancel out the losses on the underlying debt.
• Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks,
pension funds or insurance companies, may buy a CDS as a hedge for similar reasons.

• Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of
$10 million. In order to manage the risk of losing money if Risky Corp defaults on its debt, the pension
fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis
points (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of
$10 million ($200,000) per annum in quarterly installments of $50,000 to Derivative Bank.

I. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly
payments to Derivative Bank for 5 years and receives its $10 million back after five years from Risky
Corp. Though the protection payments totaling $1 million reduce investment returns for the pension
fund, its risk of loss due to Risky Corp defaulting on the bond is eliminated.
(contd.)
• If Risky Corporation defaults on its debt three years into the CDS contract,
the pension fund would stop paying the quarterly premium, and
Derivative Bank would ensure that the pension fund is refunded for its loss
of $10 million minus recovery (either by physical or cash settlement — see
Settlement below). The pension fund still loses the $600,000 it has paid
over three years, but without the CDS contract it would have lost the
entire $10 million minus recovery.
 CDS Settlement
• If a credit event occurs then CDS contracts can either be physically settled or cash
settled.
• Physical settlement: The protection seller pays the buyer par value, and in return
takes delivery of a debt obligation of the reference entity. For example, a hedge
fund has bought $5 million worth of protection from a bank on the senior debt of a
company. In the event of a default, the bank will pay the hedge fund $5 million
cash, and the hedge fund must deliver $5 million face value of senior debt of the
company (typically bonds or loans, which will typically be worth very little given
that the company is in default).

• Cash settlement: The protection seller pays the buyer the difference between par
value and the market price of a debt obligation of the reference entity. For
example, a hedge fund has bought $5 million worth of protection from a bank on
the senior debt of a company. This company has now defaulted, and its senior
bonds are now trading at 25 (i.e. 25 cents on the dollar) since the market believes
that senior bondholders will receive 25% of the money they are owed once the
company is wound up. Therefore, the bank must pay the hedge fund $5 million *
(100%-25%) = $3.75 million.
(contd.)
• The development and growth of the CDS market has meant that on many
companies there is now a much larger outstanding notional of CDS
contracts than the outstanding notional value of its debt obligations. (This
is because many parties made CDS contracts for speculative purposes,
without actually owning any debt for which they wanted to insure against
default.)

• For example, at the time it filed for bankruptcy on September 14, 2008,
Lehman Brothers had approximately $155 billion of outstanding debt but
around $400 billion notional value of CDS contracts had been written
which referenced this debt.

• Clearly not all of these contracts could be physically settled, since there
was not enough outstanding Lehman Brothers debt to fulfil all of the
contracts, demonstrating the necessity for cash settled CDS trades. The
trade confirmation produced when a CDS is traded will state whether the
contract is to be physically or cash settled.