Credit Default Swaps (CDS) often serve as the market’s pulse on a company’s likelihood of default, and few stories illustrate this better than the fall of Credit Suisse. Once a banking titan, Credit Suisse found itself teetering on the edge in early 2023, undone by risky investments and internal turmoil. By March 17, the bank’s one-year CDS had skyrocketed from 240 to a staggering 3,280 basis points, sending shockwaves through the market and signalling deep concern over its future. Just two days later, in a dramatic turn of events, UBS swooped in, acquiring the beleaguered institution for a mere US$3.25 billion, closing the chapter on a global banking giant…..

So, What is Credit Default Swaps?

Imagine a financial world where the risk of lending is like standing on the edge of a cliff, uncertain, unpredictable, and potentially catastrophic. Then, out of the innovation labs of Wall Street in the mid-1990s, a powerful tool emerges: the Credit Default Swap (CDS). Suddenly, that cliff seems less daunting. Banks, financial institutions, and investors find themselves armed with a shield that allows them to hedge or even speculate on the credit risk of various entities, from corporations to sovereign governments, all the way to complex securitized products like Asset-Backed Securities (ABSs).

CDS have since evolved into one of the most critical innovations in the world of credit derivatives, reshaping the landscape of the Debt Capital Markets. According to the ISDA SwapsInfo 2024 Q1 review, corporate single-name CDS trades now account for a staggering 75.5% of all security-based credit derivative transactions. CDS is no longer just about risk mitigation, it has become essential for managing credit exposure across global markets, influencing trading activities and allowing institutions to navigate the treacherous waters of credit risk with greater confidence and agility.

Although the contract is called a Credit Default Swap (CDS), it does not function like other swap contracts such as Interest Rate Swaps, Foreign Exchange Swaps, or Equity Swaps. CDS does not involve the actual exchange of securities. In a CDS, the underlying asset is the credit risk. In other words, a CDS swaps the credit risk from the buyer to the seller, with the seller receiving premiums for taking on the risk.

Understanding Credit Default Swaps‍

Imagine a CDS as a safety net in the financial world. It’s a contract where the protection buyer pays an upfront cost and regular premiums to a protection seller. In return, if the reference entity, regardless be it a corporate, financial institution, or government, defaults or restructures its debt, the seller compensates the losses to the buyer. It’s like an insurance policy against credit risk, ensuring that if disaster strikes, there’s a financial cushion in place. The compensation usually equals the face value of the debt minus its recovery value, essentially making the buyer whole for their loss.

For example in a real-life scenario, say Jason is a tennis athlete who wants to protection for his physical health (where his body health is analogous to a bond). He then finds an insurance company and purchases an accident insurance policy (where the policy is analogous to a CDS contract). In this case, Jason pays upfront payment and premiums to the insurance company (the protection seller), and in return, the insurance company provides financial protection for Jason’s health. If Jason gets injured (similar to when the bond issuer defaulting and unable to pay interest and principal), the insurer is obligated to cover Jason’s medical expenses (just as a CDS seller pays the CDS buyer for their losses).

Construction of Credit Default Swaps

The construction of a CDS involves several key components:

Reference Entity: The borrower whose credit risk is being insured. This could be a corporate entity, a government, or a structured finance product like mortgage-backed securities.

Reference Obligation: The specific debt instrument or obligation that is being referenced in the CDS contract. It could be a bond or a loan issued by the reference entity.

Credit Events: These are the specific events that trigger the CDS contract. Typical credit events include bankruptcy, failure to pay, and restructuring. The exact definitions of these events are outlined in the CDS contract/term sheet and standardized by organizations like the International Swaps and Derivatives Association (ISDA).

Notional Amount: The face value of the reference obligation that the CDS is written on. This amount represents the maximum possible payout by the protection seller.

Upfront Payment: The upfront amount in a CDS is a payment made at the inception of the swap, either by the buyer or the seller, to balance the contract (if spread>Coupon, pay by protection buyer, else, pay by protection seller).

Premium or Spread: The regular payments will be made by the protection buyer to the protection seller, often expressed as a percentage of the notional amount. The spread reflects the perceived credit risk of the reference entity.

Maturity: The term or duration of the CDS contract, which can range from one to several years.

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The CDS contract usually traded over-the-counter (OTC) market and is typically standardized by ISDA agreements to ensure consistency and enforceability. The standardization helps in creating a liquid market for CDS contracts, allowing them to be used not only for hedging but also for speculative purposes.

Payments of Credit Default Swaps

A CDS is composed of an upfront payment and a standardised fixed coupon paid on a regular basis over the life of the trade. These two components are tied to the CDS spread, which is set to ensure the present value of the trade starts at zero. Like any credit spread, this reflects the market's view of the reference entity’s credit-worthiness, the lower the credit rating, the higher the premium and the corresponding par CDS spread. Since the fixed coupon is standardized, the present value of a CDS rarely aligns with par, requiring an upfront payment to offset the off-market value and balance the trade.

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Risk Factors in Credit Default Swaps

While CDS contracts provide significant benefits to the protection buyer, they also come with inherent risks that market participants must carefully consider. These risk factors can be broadly categorized into the following:

Counterparty Risk: Counterparty risk, or credit risk, is the possibility that the protection seller may fail to meet their contractual obligations in the event of a credit event. If the protection seller defaults, the protection buyer might not receive the promised compensation, leading to potential financial losses (Principal of the underlying and CDS’s premiums).

Mitigation: To mitigate counterparty risk, market participants often engage in collateral agreements, where the protection seller posts collateral to guarantee their obligations. Another approach is to transact with highly creditworthy counterparties or use central clearinghouses for CDS contracts.

Market Risk: Market risk in CDS trading arises from fluctuations in the market value of the CDS spread due to changes in the credit quality of the reference entity, interest rates, or overall market conditions. A widening spread usually indicates increasing credit risk, while a tightening spread suggests improving creditworthiness.

Potential impact: Traders and investors exposed to market risk may experience gains or losses based on the movement of the CDS spread. Unanticipated changes in the credit profile of the reference entity can lead to significant volatility.

Liquidity Risk: Liquidity risk refers to the potential difficulty in buying or selling CDS contracts in the secondary market without significantly impacting the price. CDS contracts on less liquid reference entities or during periods of market stress may experience higher liquidity risk.

Potential impact: Liquidity risk can lead to wider bid-ask spreads, increased trading costs, and potential difficulty in unwinding positions, especially during times of financial crisis or when the creditworthiness of the reference entity is in question.

Model/Pricing Risk: Model risk arises when the pricing and risk management models used to value CDS contracts are based on incorrect assumptions or inputs. Given the complexity of CDS contracts, the models used for pricing and risk assessment play a crucial role in decision-making.

Systemic Risk: Systemic risk pertains to the broader impact of CDS on the financial system. The interconnectedness of financial institutions through CDS contracts can amplify stress during periods of market turmoil, potentially leading to a cascading effect on the global financial system.

Example: The 2008 financial crisis highlighted the systemic risk posed by CDS contracts, where the collapse of major institutions like Lehman Brothers had widespread ramifications due to their extensive CDS exposures.  

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Applications of Credit Default Swaps

CDS contracts serve multiple purposes in the financial markets:

Hedging: One of the primary uses of CDS is for hedging credit risk. Financial institutions, such as banks and asset managers, purchase CDS protection to safeguard their portfolios against the default of a particular borrower. By doing so, they transfer the credit risk to the protection seller.

Example: Investor Alan holding corporate bonds might purchase CDS protection on those bonds to hedge against the possibility of the corporation defaulting.

Speculation: CDS contracts are also used for speculative purposes, where investors take positions based on their views of the creditworthiness of a reference entity. Say an investor who believes a company’s credit quality will deteriorate may buy CDS protection, expecting the CDS spread to widen and the contract’s value to increase.

Example: Hedge funds often use CDS contracts to speculate on the credit risk of companies, sectors, or even countries.

Arbitrage: Arbitrage opportunities arise in the CDS market when discrepancies exist between the CDS spread and other related instruments, such as bonds or equity derivatives. Traders can exploit these discrepancies to generate risk-free profits.

Example: A trader may notice that a bond’s yield does not reflect the credit risk implied by the CDS spread and enter into offsetting positions to capture the arbitrage.

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Commonly Traded Credit Default Swaps Types

Single-Name CDS: Single-Name CDS is a contract that references the credit risk of a single entity, typically a corporation or sovereign government. This is one of the most straightforward and commonly traded CDS, as it directly relates to the creditworthiness of a particular company or sovereign.

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CDS Indices: DS indices are standardized contracts that reference a basket of single-name CDSs, representing a diversified portfolio of credit risks. Indices roll every six months in March and September. At each roll, a new series of the CDS index is created with updated constituents. The mostly popular CDS indices are CDX and iTraxx.

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Credit Default Swaps Investment

Some investors, driven by their bullish views on the financial stability of certain reference companies, choose to sell Credit Default Swaps (CDSs) that the spreads higher than the coupons in the market. By selling these CDSs, investors essentially act as insurers, collecting premiums from buyers who seek protection against potential defaults of the reference companies. Notably, this investment does not involve any initial outlay; just a steady stream of income from those premiums. This strategy allows them to generate a steady stream of income. But this strategy is not without its dangers. Should the reference companies stumble or face financial distress, the seller is on the hook for substantial payouts, which can lead to serious losses. While the allure of easy income is tempting, selling CDSs is a high-wire act requiring both confidence and deep insight into the companies’ financial health.

Disclaimer

Credit Default Swaps (CDS) are complex and high-risk instruments, often involving significant exposure to potential financial losses. Investors should approach them with caution, fully understanding the intricacies and risks involved. Given their complexity, it’s advisable to seek professional guidance before engaging in CDS trading to ensure informed and prudent decision-making.

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