Credit Default Swaps Explained

Definition of Credit Default Swap – CDS are a financial instrument for swapping the risk of debt default. Credit default swaps may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bond

  • The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.
  • The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.

Example of Credit Default Swap

  • An investment trust owns £1 million corporation bond issued by a private housing firm.
  • If there is a risk the private housing firm may default on repayments, the investment trust may buy a CDS from a hedge fund. The CDS is worth £1 million.
  • The investment trust will pay an interest on this credit default swap of say 3%. This could involve payments of £30,000 a year for the duration of the contract.
  • If the private housing firm doesn’t default. The hedge fund gains the interest from the investment bank and pays nothing out. It is simple profit.
  • If the private housing firm does default, then the hedge fund has to pay compensation to the investment bank of £1 million – the value of the credit default swap.
  • Therefore the hedge fund takes on a larger risk and could end up paying £1million

The higher the perceived risk of the bond, the higher the interest rate the hedge fund will require.

Example of Credit Default Swap

Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a £1,000 bond.

Lloyds TSB may then purchase a credit default swap from another company e.g. a Hedge Fund.

If the firm (Riskymortgage.co.uk) default on the loan, then the hedge fund will pay Lloyds TSB the value of the loan.

Thus Lloyds TSB have insurance against loan default. The hedge fund has the opportunity to make profit, so long as the firm does not default on the loan.

The more risky the loan, the higher will be the premium required on buying a credit default swap.

Why Would People Buy Credit Default Swaps?

1. Hedge against risk. Suppose an investment fund owned mortgage bonds from riskymortgage.co.uk. It might be worried about losing all its investment. Therefore, to hedge against the risk of default, they could purchase a credit default swap from Lloyds TSB. If riskymortgage.co.uk defaulted, they will lose their investment, but receive a pay-off from Lloyds to compensate. If they don’t default, they have paid a premium to Lloyds but have had security.

2. Speculation e.g. risk is underpriced.

Suppose a hedge fund felt riskymortgage was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt was defaulted, then they would make profit from Lloyds TSB. Note you don’t have to actually own debt to take a credit default swap.

Clearly the more risky a bond is the higher premium will be required from a buyer of a credit default swap. It is argued that credit default swaps provide an important role in indicating the riskiness / credit worthiness of a firm.

3. Arbitrage

If a company’s financial position improves, the credit rating should also improve and therefore, the CDS spread should fall to reflect improved rating. This makes CDS more attractive to sell CDS protection. If the company position deteriorated, CDS protection would be more attractive to buy. Arbitrage could occur when dealers exploit any slowness of the market  to respond to signals.

Credit Default Swaps in Markets

The first credit default swap was introduced in 1995 by JP Morgan. By 2007, their total value has increased to an estimated $45 trillion to $62 trillion. Although since only 0.2% of investment companies default, the cash flow is much lower than this actual amount.

The size of the credit default market dwarfs that of the stock market and the bond market they represent. Therefore, this shows that credit default swaps are being used for speculation and not insuring against actual bonds.

Credit Default Swaps are unregulated and because they get traded so frequently there is uncertainty of who owns them and whether the holders can actually pay in the event of a negative credit event.

Credit Default Swaps and Credit Crisis

Some have suggested credit default swaps have exacerbated the financial crisis of 2008. E.g. When Lehman Brother went bankrupt, it meant a lot of credit default guarantees would go unrewarded. E.g. Washington Mutual bought corporate bonds in 2005 and hedged their exposure by buying CDS protection from Lehman brothers. With Lehman brothers going bankrupt this CDS protection was nullified.

Others say that credit default is only an instrument reflecting changes in risk and are not the cause of the underlying liquidity problems

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