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. I am working on a financial prequalification criteria project. I am trying to develop scoring criteria based on credit default swap traded over the counter as basis for determining the financial solvency of bidders.

    I will appreciate some help on the variables and dimensions that indicate the financial state on a scale of 1 to 5 with 5 as the highest.

    Furthermore, an insight into the application of credit default swap in case of companies doing business internationally and in developing countries in africa.

  2. Chk the second example of lloyds.
    lloyds has lend loan to RCU.
    a) Why would HF pay premium to llyods?
    b) As rightly pointed out by mohit why would llyods pay HF???

  3. Hi. I’m confused about something. Generally when CDS spreads tighten, it’s seen as a good thing – risk decreasing, etc. But if I have bought a CDS at (say) 50bps and it tightened to 40bps, haven’t I made a loss? So by this logic, buyers of CDS want spreads to go up?

  4. Are the cds a hybrid between a contract of gaurantee and a contract of insurance only thing traded in capital markets to hedge risk?

  5. I don’t think anyone has answered #7 Thomas Walsh. His quote: “If a CDS buyer does not own the debt being insured, this is gambling – pure and simple. Banks have become bookie agencies and governments are expected to cover their losses.”

    Mr. Walsh I would argue that: My bank holds title to my car. My car is insured, but not with the bank. If my car is totaled the insurance company covers my bank loan. State Farm can pay the bank balance of my loan off AT THE TIME OF THE LOSS (not at the time of purchase).

    My question, respectfully, is: Do you believe State Farm is gambling with car insurance?

    Thanks,
    Austin

  6. #14 Jan,

    JP Morgan had two women (yes women) that came up with the CDS.

    They were not in the commercial lending side, they were working Swaps. i.e. you have a fixed mortgage I have a variable. I want the JP to write up a contract so I can make your monthly payments for 3 months as you make mine for 3, trading off and on. We can’t trade our mortgages so JP has to find a way to contractually structure the “Swap”. That’s only one example of a trade/swap.

    In 1995 Exxon asked for a $4.8 B dollar line of credit to cover the oil spill. JP was NOT going to outsource the line of credit (who wants to lose Exxon as a customer). But it really wasn’t fair that JP would have to reserve $8.00 on every $100.00. This was a regulation on a bank that had top of the line creditors. So the young ladies, one who drove a Harley :-), went to work to find a way to transfer the risk of Exxon defaulting on the line of credit should it become a loan. They found an off-shore government source that would take yearly payments to assume the possibility of Exxon defaulting. The government did not require the actual loan be transferred because they felt there was no chance of Exxon defaulting.

    The lawyers had the problem stated in an other post of “gambling”. When the contract was completed it covered only the actual default on the part of Exxon. The lawyers in the contract expressly referred to it as a “Credit Default” as opposed to a foreclosure, because only the lender holding the loan could foreclose.

    Jan, this is only what I came up with to explain the term: Credit Default Swaps.

    Thanks,
    Austin

  7. Limited liability on CDS payments, meaning the US Govt only payoff swaps that were used to hedge risk (not speculate with swaps) was one option not taken by the Treasury that would have been both fair and economical. But we did not go there. Follow this: The Treasury paid and continues to pay AIG claims 100-cents on the dollar on mortgage defaults (loans). Owners of the loans (banks) who bought CDS insurance have been made whole for any loss resulting from non-payment. But homeowners are still obligated to pay their mortgages (in arrears) even though these non-payments have effectively been paid for, month-after-month, by US taxpayers. So, the banks stand to earn double – should defaulting homeowners become current with their debt and if they don’t, they can foreclose and effectively make a windfall. Doesn’t sound fair to me. Every dollar the taxpayer paid to keep mortgages current should reduce the obligation. If the taxpayer was there to help, the help should go to the distressed homeowner not the banker who has mitigated his risk.

  8. I have been looking every where for an example of how CDS are traded. If I own a CDS and am currently paying 50bps to the issuer, then the price people are willing to pay for the CDS rises to 80bps and I sell it to John Smith, does John Smith then pay me 80 bps while I continue paying 50bps to the issuer? Or is that not how it works?

  9. Hi,
    I read today in the The Wall Street Journal – Asia edition that a Texas hedge-fund bagged millions of US$ using CDS and betting on Greece and other European countries debts.
    Beside the “morality” and risks attached to this speculative transaction, how individuals can take advantage of such schemes ?

  10. Hi,
    I don’t understand how to combine arbitrage pricing theory, Mertons theory – the debt and equity can be illustrated as european options and the CDS spread.

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