A credit
default swap (CDS) is an instrument to transfer the
credit risk of fixed income products . Using technical terms,
it 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. The buyer of a credit swap
receives credit protection. The seller 'guarantees' the credit
worthiness of the product. In more technical language, 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).
Simply, the risk of default is transferred from the holder of
the fixed income security to the seller of the swap. For example,
a mortgage bank, ABC may currently have its credit default swaps
trading at 265 basis points (bp). In other words, it costs 265,000
euros to insure 10 million of its debt per year. A year before,
the same CDS might have been trading at 7 bp, indicating that
markets now view ABC as facing a greater risk of default on
its mortgage obligations.
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 also be used to speculate on changes in credit spread.
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.
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 CreditWatchTM
to help evaluate credit swaps among other financial instruments.
By the end
of 2007 there were an estimated USD 45 trillion worth of Credit
Default Swap contracts.[2]
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).
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.
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 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]
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.
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.
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.
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.
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 ti − 1 to ti without a default payment is
pi and the
probability of a default being triggered is 1
− pi. The calculation of present
value, given discount factors of 1
to ´4 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
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.
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.
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.
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..
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.
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
References
- British Banker Association Credit Derivatives Report.
-
Morgensen, Gretchen. "Arcane Market Is Next to Face Big Credit Test", The New York
Times, 2008-02-17. Retrieved on 2008-02-17.