A credit default swap is a financial instrument for swapping the risk of debt default.
- 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 has 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.
How Credit Default Swaps are used
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 default, they will lose their investment but receive a payoff from Lloyds to compensate. If they don’t default, they have paid a premium to Lloyds but have had security
2. Because they think the risk is underpriced.
Suppose a hedge fund felt risky mortgages was very likely to default because of a rise in home repossessions. They would buy a credit default swap. If the debt has 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.
Clearly the more risky a bond is the higher premium will be required from a buyer of a credit default swap.
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 the US
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.
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 the 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.