A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement). A contract is any legally-enforceable promise or set of promises made by one party to another and, as such, reflects the policies represented by freedom of contract. ... A counterparty is a legal and financial term. ... Credit risk is the risk of loss due to a debtors non-payment of a loan or other line of credit (either the principal or interest (coupon) or both). ... In finance, default occurs when a debtor has not met its legal obligations according to the debt contract, e. ...

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread. In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. ... Insurance, in law and economics, is a form of risk management primarily used to hedge against the risk of a contingent loss. ...

Credit default swaps are the most widely traded credit derivative product^[1]. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded. // A credit derivative is a financial instrument or derivative (finance) whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded. ... Derivatives traders at the Chicago Board of Trade. ...

History

In 1995, J.P. Morgan's Blythe Masters (a 26-year old Cambridge University graduate hired by the bank), developed the first Credit Default Swaps and Collateralized Debt Obligations (CDO). On April 2nd, 2007, Masters (who by then was the head of J.P. Morgan's Global Credit Derivatives group), helped introduce CreditWatch^TM to help evaluate credit swaps among other financial instruments. A cash flow collateralized debt obligation, or cash flow CDO, is a structured finance product that typically securitizes a diversified pool of debt assets. ...

By the end of 2007 there were an estimated USD 45 trillion worth of Credit Default Swap contracts.^[2] Look up trillion in Wiktionary, the free dictionary. ...

Market

The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion[[1]] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). BIS Headquarters in Basel The Bank for International Settlements (or BIS) is an international organization of central banks which exists to foster cooperation among central banks and other agencies in pursuit of monetary and financial stability. It carries out its work through subcommittees, the secretariats it hosts, and through its... Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. ...

In the US, the Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from 882 reporting banks to be $5.472 trillion at the end of March, 2006. The Office of the Comptroller of the Currency (or OCC) was established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States. ...

Structure and features

Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the 2003 Credit Derivatives Definitions as published by the International Swaps and Derivatives Association. The confirmation typically specifies a reference entity, a corporation or sovereign which generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date. The International Swaps and Derivatives Association (ISDA) is a trade organization of participants in the market for over-the-counter derivatives. ... A corporate bond is a bond issued by a corporation. ... A government bond is a bond issued by a national government denominated in the countrys own currency. ...

The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations, and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will trigger a credit event and give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include 'restructuring' as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to pick up circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings. This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco's restructuring in 2000 led to the credit event's removal from North American high yield trades.^[2] A bond is considered investment grade or IG if its credit rating is BBB- or higher by Standard & Poors or Baa3 or higher by Moodys or BBB(low) or higher by DBRS. Generally they are bonds that are judged by the rating agency as likely enough to meet... Chapter 11 of the Bankruptcy Code governs the process of reorganization under the bankruptcy laws of the United States. ... Bankruptcy in the United States is a matter placed under Federal jurisdiction by the United States Constitution (in Article 1, Section 8, Clause 4), which allows Congress to enact uniform Laws on the subject of Bankruptcies throughout the United States. The provision, however, is not self-executing and is implemented... Conseco NYSE: CNO is a financial services organization based in Carmel, Indiana, which had its origin as Security Life of Indiana. ...

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due. Rule 144A, adopted pursuant to the U.S. Securities Act of 1933, as amended the Securities Act provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private resales of restricted securities to QIBs (qualified institutional buyers), which generally are large institutional investors with...

Quotes of a CDS contract

Sellers of CDS contracts will give a par quote (see par value) for a given reference entity, seniority, maturity and restructuring e.g. a seller of CDS contracts may quote the premium on a 5 year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. The par premium is calculated so that the contract has zero present value on the effective date. This is because the expected value of protection payments is exactly equal and opposite to the expected value of the fee payments. The most important factor affecting the cost of protection provided by a CDS is the credit quality (often proxied by the credit rating) of the reference obligation. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher. Par value has several meanings depending on the context, whether used in the equities market, or in the bond markets, and partially also dependent on where in the world the par value term is used. ... A basis point (often denoted as bp, bps or ; rarely, permyriad) is a unit that is equal to 1/100th of 1%. It is commonly used to denote the change in a financial instrument, or the difference (spread) between two interest rates; although it may be used in any case... The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ... In probability theory the expected value (or mathematical expectation) of a random variable is the sum of the probability of each possible outcome of the experiment multiplied by its payoff (value). Thus, it represents the average amount one expects as the outcome of the random trial when identical odds are... A credit rating assesses the credit worthiness of an individual, corporation, or even a country. ...

The swap adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical minutiae such as specific settlement differences, shortages in a particular underlying instrument, and the existence of buyers constrained from buying exotic derivatives. The difference between CDS spreads and Z-spreads or asset swap spreads is called the basis.

Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default swaps. The first, which for convenience we will refer to as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by Hull and White, uses a no-arbitrage approach. J. Darrell Duffie is super cool, amazing, and generally awesome. ...

Under the probability model, a credit default swap is priced using a model that takes four inputs: the issue premium, the recovery rate, the credit curve for the reference entity and the LIBOR curve. If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a one year CDS with effective date t₀ with four quarterly premium payments occurring at times t₁, t₂, t₃, and t₄. If the nominal for the CDS is N and the issue premium is c then the size of the quarterly premium payments is Nc / 4. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end: either it does not have any default at all, so the four premium payments are made and the contract survives until the maturity date, or a default occurs on the first, second, third or fourth payment date. To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring. LIBOR stands for the London Interbank Offered Rate and is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale (or interbank) money market. ... In finance, default occurs when a debtor has not met its legal obligations according to the debt contract, e. ... In finance, the discounted cash flow (or DCF) approach describes a method to value a project, company, or financial asset using the concepts of the time value of money. ... The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value of money, and other factors such as investment risk. ...

This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of N(1 − R) shown in red, where R is the recovery rate, or it survives without a default being triggered, in which case a premium payment of Nc / 4 is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.

Image File history File links Cds_cashflows. ...

The probability of surviving over the interval t_{i − 1} to t_i without a default payment is p_i and the probability of a default being triggered is 1 − p_i. The calculation of present value, given discount factors of δ₁ to δ₄ is then In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash from the basis of time value of money calculations. ...

Description	Premium Payment PV	Default Payment PV	Probability
Default at time t1
Default at time t2
Default at time t3
Default at time t4
No defaults

The probabilities p₁, p₂, p₃, p₄ can be calculated using the credit spread curve. The probability of no default occurring over a time period from t to t + Δt decays exponentially with a time-constant determined by the credit spread, or mathematically p = exp( − s(t)Δt) where s(t) is the credit spread zero curve at time t. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time. In finance, a credit spread is the difference in yield between different securities due to different credit quality. ... A quantity is said to be subject to exponential decay if it decreases at a rate proportional to its value. ... In finance, a credit spread is the difference in yield between different securities due to different credit quality. ...

To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give

In the 'no-arbitrage' model proposed by both Duffie, and Hull and White, it is assumed that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default) which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However owing to inefficiencies in markets, this is not always the case. The difference between the theoretical model and the actual price of a credit default swap is known as the basis. There is very little academic research which identifies the factors that cause the basis to expand and contract

Uses

Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads. In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. ...

Hedging

Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million which trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. 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 loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario is eliminated. If Risky Corporation defaults on its debt 3 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 (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market. For alternative meanings, see bond (a disambiguation page). ... Nominal or notional amounts outstanding are defined as the gross nominal or notional value of all deals concluded and not yet settled on the reporting date. ... A basis point (often denoted as bp, bps or ; rarely, permyriad) is a unit that is equal to 1/100th of 1%. It is commonly used to denote the change in a financial instrument, or the difference (spread) between two interest rates; although it may be used in any case...

Speculation

Credit default swaps give a speculator a way to make a large profit from changes in a company's credit quality. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity, with a value equal to the notional amount of the CDS contract.

For example, if a company has been having problems, it may be possible to buy the company's outstanding debt (usually bonds) at a discounted price. If the company has $1 million worth of bonds outstanding, it might be possible to buy the debt for $900,000 from another party if that party is concerned that the company will not repay its debt. If the company does in fact repay the debt, you would receive the entire $1 million and make a profit of $100,000. Alternatively, one could enter into a credit default swap with the other investor, by selling credit protection and receiving a premium of $100,000. If the company does not default, one would make a profit of $100,000 without having invested anything.

It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds themselves, the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. Swap prices typically decline when creditworthiness improves, and rise when it worsens. But these pricing differences are amplified compared to bonds. Therefore someone who believes that a company's credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds (although encountering a greater loss potential).

Criticisms

Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction." In Berkshire Hathaway's annual report to shareholders in 2002, he said "Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars. Warren Edward Buffett (born August 30, 1930, in Omaha, Nebraska) is an American investor, businessman and philanthropist. ... Berkshire Hathaway (NYSE: BRKA, NYSE: BRKB) is a conglomerate holding company headquartered in Omaha, Nebraska, U.S., that oversees and manages a number of subsidiary companies. ...

The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably.

Another major issue is the vast difference in knowledge concerning the creditworthiness of the underlying borrower. Major banks and investment banks, like JP Morgan Chase, Citigroup, Bank of America, Merrill Lynch, Goldman Sachs, Lehman Brothers, etc., are usually the originators of syndicated loans or the underwriters of stock and bonds of the companies in question. Credit swaps are issued, by these same banks, against the credit of those companies. JP Morgan and its cousins have a much better idea whether or not particular borrowers are really at risk of default, because of their relationships with those borrowers. This can be deemed "inside" information, which would be illegal to possess while actively trading in a particular market, in almost any other field of market activity. Yet, within the credit default swap trading community, insider trading is not only a given, but is the fundamental basis upon which the entire structure depends. Indeed, these same major banking institutions also dominate the market for issuance of derivatives, generally.

Derivatives such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder why indices like the Dow Jones Industrial Average and S&P 500 seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities issued by such companies may retain significant paper value up until almost the very end. Instead of selling, investors can buy "insurance" in the form of derivatives and keep holding their investments. This distorts the value of traditional market indices because the decision to remove a failing company from the index can be made well before the paper value drops to zero. This saves the value of the index. It creates the false impression that the index always rises. The underlying markets, for which the index was developed to reflect value, may be far more unstable than appearances indicate. False appearances of stability allow securities markets to appear far less risky than they really are, encourage less knowledgeable players to speculate on derivatives, and allow broker/dealers, financial journalists and some academics to claim that markets are far better investments for the retail investor than they really are. The overall effect is to reduce the perception of risk even though the risk still exists. The reduced perception, however, reduces risk premiums and encourages shoddy loan practices, and may be the cause of runaway financial bubbles, when irrational exuberance gains traction on the basis of inaccurate information.

However, for informed investors, CDS premiums can act as a good barometer of company's health. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default.

Operational issues in settlement

In the US, the settlement and processing of a CDS contract is currently the subject of concern by the US Federal Reserve. In 2005, the Federal Reserve obtained a commitment by 14 major dealers to upgrade their systems and reduce the backlog of "unprocessed" CDS contracts. As of January 31, 2006, the dealers had met their commitment and achieved a 54% reduction.^[3]

In addition, growing concern over the sheer volume of CDS contracts potentially requiring physical settlement after credit events for names actively traded in the single-name and index-trade market where the notional value of CDS contracts dramatically exceeds the notional value of deliverable bonds has led to the increasing application of cash settlement auction protocols coordinated by ISDA. Successful auction protocols have been applied following credit events in respect of Collins & Aikman Products Co., Delphi Corporation , Delta Air Lines and Northwest Airlines, Calpine Corporation, Dana Corporation and Dura Operating Corp.. The International Swaps and Derivatives Association (ISDA) is a voluntary consortium of major derivative players that created and maintain a standard derivative contract. ... Delphi logo from 2005 Delphi (NASDAQ: DPHIQ) is an automotive parts company headquartered in Troy, Michigan. ... Delta Air Lines, Inc. ... Northwest Airlines (NYSE: NWA), occasionally known as NWA, is an American airline headquartered in Eagan, Minnesota, near Minneapolis-St. ... Calpine Corporation is a power company founded in 1984. ... Dana Corporation is an auto parts and systems company currently being reorganized under Chapter 11 bankruptcy law. ...

LCDS

A new type of default swap is the "loan only" credit default swap (LCDS). This is conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of "Bond or Loan". Also, as of May 22, 2007, for the most widely traded LCDS form which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same as that which has been used in the various ISDA cash settlement auction protocols but does not require parties to take any additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS auction was held for Movie Gallery.[4]

Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed to be cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name.

See also

• Credit derivative
• Credit default swap index
• Credit default option
• Swap (finance)

// A credit derivative is a financial instrument or derivative (finance) whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded. ... A credit default swap index is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities. ... In finance, a default option or credit default option is a put option that makes a payoff in the event the issuer of a specified reference asset defaults. ... For the Thoroughbred horse racing champion, see: Swaps (horse). ...

External links

• Explanatory Diagram from the New York Times
• 2003 ISDA Credit Derivatives Template
• BIS - Regular Publications
• OCC - Quarterly Derivatives Fact Sheet
• A Beginner's Guide to Credit Derivatives - Noel Vaillant, Nomura International
• Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer, Brown, Rowe & Maw, Euromoney Handbooks.
• A billion-dollar game for bond managers
• Hull, J. C. and A. White, Valuing Credit Default Swaps I: No Counterparty Default Risk
• Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations
• Elton et al, Explaining the rate spread on corporate bonds

In the News

• January 18, 2008, Wall Street Journal: "Default Fears Unnerve Markets" by Susan Pulliam and Serena Ng on CDS counterparty risk.
• February 5, 2008, Financial Times: "CDS market may create added risks" by Satayjit Das.
• February 17, 2008, New York Times: "Arcane Market is Next to Face Big Credit Test" By Gretchen Morgenson

References

1. ^ British Banker Association Credit Derivatives Report.
2. ^ Morgensen, Gretchen. "Arcane Market Is Next to Face Big Credit Test", The New York Times, 2008-02-17. Retrieved on 2008-02-17.