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 defaults.
  • 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 corporate 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 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 has insurance against loan default. The hedge fund has the opportunity to make a profit, so long as the firm does not default on the loan.
  • The riskier 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 risky mortgage was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt defaulted, then they would make a profit from Lloyds TSB. Note you don’t have to actually own debt to take a credit default swap.

The riskier 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/creditworthiness 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 an 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

See also:

By on June 11th, 2017

43 thoughts on “Credit Default Swaps Explained

  1. Let me pose these two questions. (1) Given that the Federal Reserve substantially discounts risk when it supports it’s “save the economy” role (instead of just “managing inflation”), is the CDS a real proxy? That is, by pricing credit risk at say 5% when the Fed is supporting 1% money? (2) And if the Federal Reserve was not propping up an economy with cheap money, would the need for a CDS be as strong, if at all?

  2. When a casino doesn’t pay off winning customers, they aren’t gambling; they are stealing.

  3. The Irish banks should have been prohibited by Irish law from entering into credit default agreements apparently insuring against loss claims which the insurer could not honour.

  4. A further cause of the Irish bank crisis is the subprime one of banks lending to debtors who are not properly secured. This could have been corrected by a system of housing benefits which could have been applied in repaying the loans.

  5. CDS are now $577 Trillion and growing. The world economy cannot pay this should the majority of creditors default.

  6. There is nothing wrong with CDS, provided that people who are not participants are not forced to cover the bet. That is why institutions should have failed. Instead, non-participants are forced to hand over the money for someone else’s gambling addiction. This is not capitalism. This is dictatorship. Thus, please do not say that they should have been regulated. It implies that it is acceptable someone to gamble with your money. If you are stupid enough to gamble with your money, it is your progative. Who am I to say what to do with your money?

  7. the two main problems with CDS are lack of regulation and lack of insurable interest. Since the CDS market is unregulated their is no requirement that the entity issuing the CDS have suffecient funds in case the insured instrument defaults. The latter problem is that you don’t have to own the bond to get a CDS on it. So let’s say a $1M bond is defaulted on and 100 people had a CDS on it then the issuer of the CDS would have to pay out 100 million on a asset with an underlying value of only 1 million dollars.

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