credit default swap (CDS)

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default^[2] or credit event in respect of a third party or "reference entity".

In the event of default in the reference entity:

• the buyer typically delivers the defaulted asset to the seller for a payment of the par value. This is known as "physical settlement".
• Or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. This is known as "cash settlement".

While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults -- a buyer doesn't necessarily have to own a bond to buy the credit default swap that insures it. When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.

Banks and other institutions have used credit default swaps to cover the risk of default in mortgage and other debt securities they hold.

CDSs are financial devices that allow banks to spread the risk of default and enable hedge funds to efficiently speculate on the creditworthiness of countries(governments), companies or consumers. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. This practice has the potential to put investors into webs of relationships which are not transparent.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

[edit] Market

Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.

Credit default swaps are the most widely traded credit derivative product.^[3] The Bank for International Settlements reported the notional amount on outstanding OTC credit default swaps to be $42.6 trillion^[4] in June 2007, up from $28.9 trillion in December 2006 ($13.9 trillion in December 2005). By the end of 2007 there were an estimated $45 trillion ^[5] to $62.2 trillion ^[6] worth of credit default swap contracts outstanding worldwide. On September 23, 2008, Christopher Cox, Chairman of the U.S. Securities and Exchange Commission, placed the worldwide CDS market at $58 trillion, and stated it was "completely lacking in transparency and completely unregulated."^[7] The U.S. Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from reporting banks to be $16.4 trillion at the end of March 2008. (For reference and perspective, the U.S. GDP for 2007 was $13.8 trillion^[8], while the world's GDP for 2007 was estimated at $54.3 trillion ^[9])

In 2007 the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn't worked because It's been boycotted by banks, which prefer to continue their trading privately.

[edit] Auctions

Auctions, termed credit event fixings, periodically occur where batches of Credit Default Swaps are traded. These are the auctions since 2005. ^[10]

Date	Name	Final price as cents in the dollar
2005-06-14	Collins & Aikman - Senior	43.625
2005-06-23	Collins & Aikman - Subordinated	6.375
2005-10-11	Northwest Airlines	28
2005-10-11	Delta Airlines	18
2005-11-04	Delphi Corporation	63.375
2006-01-17	Calpine Corporation	19.125
2006-03-31	Dana Corporation	75
2006-11-28	Dura - Senior	24.125
2006-11-28	Dura - Subordinated	3.5
2007-10-23	Movie Gallery	91.5
2008-02-19	Quebecor	41.25
2008-10-02	Tembec Inc	83
2008-10-06	Fannie Mae - Senior	91.51
2008-10-06	Fannie Mae - Subordinated	99.9
2008-10-06	Freddie Mac - Senior	94
2008-10-06	Freddie Mac - Subordinated	98
2008-10-10	Lehman Brothers	8.625
2008-10-23	Washington Mutual

[edit] Structure and features

[edit] Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association.^[11] The confirmation typically specifies a reference entity, a corporation or sovereign that 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 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 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 respond to 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 (i.e., the debt is restructured). 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.^[12]

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.

[edit] 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.

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.

To give an example, ABC Corporation may have its credit default swaps currently trading at 265 basis points. In other words, the cost to insure 10 million euros of its debt would be 265,000 euros per annum. If the same CDS had been trading at 170 basis points a year before, it would indicate that markets now view ABC as facing a greater risk of default on its obligations.

[edit] 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.

[edit] Probability model

Under the probability model, a credit default swap is priced using a model that takes four inputs:

• the issue premium,
• the recovery rate (survival 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.

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.

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

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.

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

[edit] No-arbitrage model

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.^{[citation needed]}

[edit] 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.

[edit] 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 the 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 that 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 due to Risky Corporation defaulting on the bond is eliminated. (However, the fund still faces counterparty risk if Derivative Bank becomes insolvent and cannot honor the CDS contract). 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.

[edit] Speculation

Credit default swaps give a speculator a way to 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.

[edit] Taxation

The U.S. federal income tax treatment of credit default swaps is uncertain.^[13] Commentators generally believe that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes,^[14] but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).^[15] If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income.^[16] If a payment is a termination payment, its tax treatment is even more uncertain.^[17] In 2004, the Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to taxpayer confusion,^[18] but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.^[19]

[edit] 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.^[20] Berkshire Hathaway, with a market capitalization of $196 billion^[21], certainly does have enough equity to collateralize or guarantee these contracts.

The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $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. When the CDS have been made for purely speculative purposes, in addition to spreading risk, credit derivatives can also amplify those risks. If the CDS were being used to hedge, the notional value of such contracts would be expected to be less than the size of the outstanding debt as the majority of such debt will be owned by investors who are happy to absorb the credit risk in return for the additional spread or risk premium. A bond hedged with CDS will, at least theoretically, generate returns close to LIBOR but with additional volatility. Long term investors would consider such returns to be of limited value. However speculators may profit from these differences and therefore improve market efficiency by driving the price of bonds and CDS closer together.

However 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. For example the credit spread of Bear Stearns widened significantly in the period immediately prior to being bailed out by the Fed and JP Morgan, providing equity investors with advance warning of impending problems at the company.^{[citation needed]}

It acts like 'insurance' but isn't. "It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," according to Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodity Futures Trading Commission. ^[22] The deregulation of the swaps market is thanks to provisions in The Commodity Futures Modernization Act of 2000.

Swap prices are hard to find^{[citation needed]}. Traders looking up prices on the Internet or on private trading systems see information that is hours or days old^{[citation needed]}.

[edit] 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.^[23]

In addition, growing concern over the volume of CDS contracts potentially requiring physical settlement after credit events for names actively traded in the single-name (only one reference entity^[24]) and index-trade market (where the notional value of CDS contracts significantly exceeds the notional value of deliverable bonds) has led to the increasing application of cash settlement auction protocols coordinated by ISDA^{[citation needed]}. Successful auction protocols have been applied following credit events in respect of Collins & Aikman, Delphi Corporation, Delta Air Lines and Northwest Airlines, Calpine Corporation, Dana Corporation, Dura Operating Corporation and Quebecor. ISDA is also using a protocol for the settlement of contracts on Fannie Mae and Freddie Mac debt, after these entities were placed in conservatorship.^[25]

One large difference between credit default swaps and insurance, is you do not need to own the bond or instrument being insured in order to obtain insurance on it. If the bond fails, then, theoretically, you get paid, possibly along with many others. Yet the "insurer" of the bond is not regulated and the transaction is beyond federal or state regulation. This allow speculators to make money by purchasing insurance on a company's bonds and then shorting the stock of the company in great quantity and getting a payoff that exceeds their risk of shorting if the price of the company's stock increases. The fact that you need not be a party to owning the bond also explains why the total value of credit default swaps is so high, indeed higher than the total value of the bonds issued.

[edit] 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 that 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.[7]

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.