Introduction
On our team at work we occasionally employ developers who know nothing about derivatives. It usually falls to me to give these guys a general introduction to the credit derivatives business. As part of that we usually have a session on what a credit default swap is and why it’s important. This article is based on what I say in that session, and as such is an attempt to explain the product to someone who knows very little about the financial services industry.
It isn’t really possible to understand a credit default swap without having a basic understanding of bonds, so we’ll start with a discussion of what bonds are and why someone might invest in one.
Imagine I have some cash and I want to invest it for a long period. Furthermore assume that interest rates are high and I want to ensure I get a high rate of interest for the period. I would ideally like a fixed interest rate. One way of doing this would be to go to my bank and see what they have on offer. However, most banks don’t offer very generous fixed rate deposits, especially over long periods. They prefer to offer you a variable rate.
An alternative is to buy a bond from the government. To raise money almost all governments periodically issue these bonds. The way they work is that you give your money to the government. The government then pays a fixed rate of interest periodically (usually every six months) on the money you give them. The government does this for a fixed period, usually of several years. At the end of the fixed period they will give you your money back. The end of the fixed period is called the ‘maturity’ of the bond. The amount they pay interest on is called the ‘face value’, the ‘notional value’ or the ‘principal’ of the bond.
What makes this even more attractive as an option is the fact that there is a ‘secondary market’ for bonds. What that means is that there is someone who will buy the bond from me should I not want to hold it to maturity. This is like the stock market. You can buy stocks from individual companies when they issue them, and then (usually) sell them on a stock exchange when you no longer wish to hold the stock. In both cases the price you get will depend on market conditions at the time. Clearly the current level of interest rates will have a major impact on the price you can get when you come to sell your bond. Of course you can buy your bond in the secondary market in the first place, rather than buying it directly from the government.
Should you actually want to do this most of the major stockbrokers will also allow you to trade government bonds, although some cheap online brokers won’t.
So for example, if I look on the US TreasuryDirect site right now I can see that on the 15th August 2007 the US government issued a bond that has a maturity of 15th May 2037 with an interest rate of 5% per year. This is paid every six months (so I get 2.5% of the face value of the bond every six months).
Note that in the United States government bonds issued with a period to maturity of between ten and thirty years are called ‘Treasury bonds’, whilst government bonds issued with a period to maturity of two to ten years are called ‘Treasury notes’. However, these instruments all behave as described above, and are often just referred to as ‘government bonds’.
It’s not only governments that issue bonds, companies do so as well. This is a way of raising money for them, the other alternative being to issue stock. These corporate bonds are typically very like the government bonds discussed above: the company will pay you a fixed interest rate on your money for a fixed period. There’s also a secondary market for these bonds as described above for government bonds.
If you are given the choice between a 10-year corporate bond issued by, say, General Motors (a car company) and a US government bond, which one would you prefer? If the interest rates were the same you’d be wise to go for the US government bond. This is because there’s almost no chance that the US government won’t pay you back your money. It’s going to take a world war or something similar for the US government to be in such trouble that it can’t repay (and in that case you’d probably have bigger worries than your bonds). However, companies can get into financial trouble, even big ones (think of WorldCom, or Enron). If a company goes bankrupt there’s a chance you won’t get all the money you’ve given them for the bond back.
For this reason companies are forced to pay a higher rate of interest on their bonds than the US government. Otherwise no-one will give them the money for their bonds. How much bigger the rate of interest has to be depends on how risky the company is perceived to be.
For example General Motors has issued a bond that matures on the 15th July 2033 paying 8.375%. Whilst this interest rate isn’t directly comparable with that on the US Treasury bond discussed above, if you do work out the numbers you will find that you are getting much more interest from the General Motors bond. This article isn’t going to go into the details of how to do this, as it isn’t strictly relevant to understanding credit default swaps.
Further Reading on Bonds
The sections above have given a very simple overview of bonds. These sections have not described how the secondary markets work, how we price bonds, what a yield is or what yield curves are. If you are interested in such things there are some more details at the links below:
http://www.investopedia.com/university/bonds/
http://www.riskworx.com/resources/Yield%20Curves_RiskWorX.pdf
Credit Default Swaps (CDS)
Suppose that we have invested in the General Motors bond mentioned above. Suppose our investment is $10,000,000. Suppose also that we have become worried that General Motors may be getting into financial trouble. What can we do about it? Obviously we could just sell our bond position in the secondary market. However, we can also enter into a credit default swap. The easiest way to think of a credit default swap is as an insurance contract. We are insuring against the possibility that a company might get into financial trouble and cause us to lose money on our bond position.
To enter into this insurance contract we have to find someone prepared to insure us. Note that this is NOT General Motors. The big banks are usually the people to go to.
What we can do is to pay the bank a periodic small amount of money known as a ‘premium’ (which is like an insurance premium). This is calculated as a percentage of the face value of the bond we are insuring against, which is $10m in our case. This amount (the $10m) is known as the ‘notional principal’. The premium is paid every few months (usually every three or six months) throughout the life of the contract.
In return for the premium the bank does nothing unless General Motors gets into financial difficulty. In that case the bank will pay us an amount equal to the amount we have lost on our bond position. This is likely to be a big sum relative to the small premiums that we will pay. Once this happens the contract will terminate. Otherwise the contract carries on for an agreed period (usually five years). In picture form this looks a bit as below:
Here the Big Bank is the ‘protection seller’: it’s receiving money in return for providing protection against our bonds falling in value. Similarly we are ‘protection buyers’.
Clearly there are a few things that need to be sorted out before we enter into this contract. Since the Big Bank is going to make us a large payment if General Motors gets into financial difficulty we’d better define what ‘financial difficulty’ means very clearly. We’d also better sort out exactly how we’re going to calculate the amount that will be paid.
Physical Settlement and Cash Settlement
The amount to be paid is slightly the easier of the two to define. We know which bond we want insurance on (the one we are holding), and we know we want to get the reduction in its value as a result of General Motors getting into trouble. There are two ways of handling this. The first is known as ‘physical settlement’. Here we give the bond to the Big Bank, and the Big Bank gives us the full face value of the bond in return (i.e. the amount that was originally paid to General Motors for it). The bank will then try to dispose of the bond in the market. Note that it will be worth much less than the full face value. This is because General Motors is in difficulty and hence unlikely to pay back the full face value at maturity. So from our point of view we’ve given up our bond but been paid face value for it: we’ve been compensated for the reduction in the value.
The second method is known as ‘cash settlement’. Here we try to work out the reduction in value of the bond, and this is just paid from the Big Bank to us in cash. To work out the reduction in value usually a ‘calculation agent’ is appointed in the CDS contract. The calculation agent will go into the market and get a selection of quotes for the bond from which a price for settlement will be calculated in an agreed way. Often the calculation agent is the seller of protection (the Big Bank in our example).
Credit Events
Defining ‘financial difficulty’ is more problematic, and indeed has led to several lawsuits already. We don’t usually call it ‘financial difficulty’, by the way. It’s referred to as a ‘credit event’, or a ‘default’. We say a credit default swap contract is ‘triggered’ if a credit event occurs, meaning the Big Bank has to pay up in our example.
There are three broad categories of credit events that are put into the documentation of credit default swap contracts:
- Bankruptcy
If a company goes into Chapter 11 (in the US) then that is a clear indicator that the company is in serious financial difficulty and that the bondholders may not get all their money back. This is an obvious thing to have trigger the payment in a CDS contract. - Failure to Pay
If a company fails to make payments it should be making, including coupon payments on the bonds, then this can be documented as a credit event. - Restructuring
This is where a company changes the payment schedules it makes on its bonds, usually with the agreement of the bondholders. It’s usually not to the bondholders advantage when this happens, and hence CDS contracts can be documented to cover this kind of restructuring as a credit event.
Of these, restructuring is the one that has proved the most problematic for the market. There are now four separate standard definitions for restructuring that can be used in CDS contracts.
Size of Premium Payment is Bigger if the Company is More Likely to Default
One question that has been asked is how large the premium will be in general (see the comments).
The Big Bank in our example is providing us with protection against the default of a company (General Motors). We are paying them the premium for this protection. Clearly if the company being referred to is more likely to default the Big Bank will want us to pay them more money. So the premium rate is higher for riskier companies than for safe ones.
The Big Bank will decide which companies it thinks are risky, and hence what premium it should charge, based on a number of factors. However, there’s already a market that reflects how risky a company is. This is the bond market as described earlier in this article. In the example there General Motors had to pay a higher interest rate on its bonds than the US Government because of the risk that the investor wouldn’t get their money back if General Motors defaulted.
Size of Premium Payment and How it Relates to Bond Prices
Now consider the case where we buy a General Motors bond. We then enter into a credit default swap to the maturity of the bond as well. This acts as insurance against General Motors defaulting on the bond. We receive interest from the General Motors bond, but pay some of it away in insurance on the credit default swap.
In simple terms we now have overall a bond position where we don’t lose anything if General Motors defaults. If a default occurs we get our money back from the credit default swap. We can then invest in another bond.
We can think of this as a risk-free bond position. This is in many ways equivalent to a position in US Government bonds (which we can assume won’t default at all). We’d expect our overall interest rate to be similar to that of a US Government bond. Our overall interest rate is the rate on the General Motors bond less the premium on the credit default swap.
Now suppose the interest rate on a US Government bond is 5% and the interest rate on a General Motors bond of the same maturity is 8%. We’d expect the premium on a credit default swap on General Motors for the same period to be about 3%. Note that the 3% premium is also called the ‘spread’ on a credit default swap, since it is the spread between the government bond and the corporate bond interest rates.
Note that this is a very simplistic analysis. It is broadly accurate but there are reasons why it doesn’t work exactly in practice.
Some Other Terminology Relating to Credit Default Swaps
(i) Reference Entity and Reference Obligation
Note above that General Motors is not directly involved in the credit default swap contract. General Motors as a company will not even know the contract exists. The contract is between us and the Big Bank. General Motors is just an entity that is referred to in the contract, and hence is known as the ‘reference entity’.
Similarly the contract refers to the specific bond we are insuring (General Motors 8.375% maturing 15th July 2033 in our example). However the bond isn’t directly involved in the contract. Indeed if the contract is cash settled we don’t even have to be holding the bond at any time: we can just enter into the CDS contract without it. The bond is just an obligation being referred to in the contract, and hence is known as the ‘reference obligation’.
You should know that, at least in technology, everyone’s favourite interview question about credit default swaps is ‘what’s the difference between a reference entity and a reference obligation?’
(ii) Bond Seniority
Bonds have a hierarchy of importance when a company is unable to pay its debts. Some bondholders will get their money back before others. (They ALL get their money back before the shareholders.) The exact place in the pecking order depends on the documentation of the bonds. Typically bonds are classified according to ‘seniority’. They are assigned to one of senior secured, senior unsecured, senior subordinated, subordinated and junior subordinated seniority categories. The list is in order of seniority: senior secured is the highest, junior subordinated the lowest. This means if we hold a senior secured bond we are more likely to get our money back if the company goes bankrupt than if we hold a junior subordinated bond.
When a company is being wound up the bondholders get paid in seniority order out of the cash that is remaining to the company. The bondholders with the highest seniority debt get paid first, then the bondholders with the next level of seniority debt, and so on. Bondholders will get paid in full in each seniority category until the money runs out. If at any stage the money is insufficient to pay the current seniority of bondholder in full, every bondholder of that seniority gets paid the same percentage of the face value of their bond. So, for example, the most senior bondholders may get paid in full, one category of more junior bondholders will only get a percentage payout, and the most junior bondholders may get nothing.
The ‘recovery rate’ is the percentage of the face value of our bond that we get back if there’s a credit event. For example, suppose we hold $10m of bonds in a company, and it goes bankrupt. Assume we get $4m back for our bonds from the company after the bankruptcy. We would say our ‘recovery rate’ is 40% (4m/10m as a percentage).
Recovery rates are also one of the inputs into pricing a CDS contract (working out its value to either counterparty) prior to maturity. To price a CDS one of the things we need to know is how much the bond we are insuring will reduce in value if a credit event occurs. This is obviously important since it determines the size of the payment made as a result of the credit event. Clearly we can’t know exactly how much the bond will be worth after a credit event before the credit event has happened, so we estimate a recovery rate.
Most pricing methodologies estimate recovery rates in a very simplistic way: a percentage is assigned to the seniority of the debt of a company. So we might say General Motors Senior Unsecured debt has a recovery rate of 40%, and then use that number for pricing all GM senior unsecured credit default swaps.
Uses of Credit Default Swaps
As described above it sounds like the credit default swap is a very niche product since its primary use is to hedge bond positions against default. However, the credit default swap market has taken off and is huge. The reason is that there is a wide range of ways CDS can be used. In recent years pure speculation, largely by hedge funds, seems to have been the main driver of the market.
Geoff Chaplin’s excellent book ‘Credit Derivatives: Risk Management, Trading and Investing’ cites the following uses of CDS:
- Directional Trading/Relative Trades (speculation on individual companies)
- Debt Hedging (hedging bond positions as described above)
- Sector/Portfolio Trades (speculation on groups of companies)
- Income Generation (we can just sell protection and receive premium, provided we’re confident we won’t face defaults (credit events))
- Regulatory Capital Reduction (if a bank has lent to a company that uses regulatory capital which can be reduced by buying CDS protection)
Issues
Below are a few further issues relating to credit default swaps:
- The description of CDS as ‘insurance’ is not technically accurate. Insurance contracts are regulated in a different way, the documentation is different, and usually an insurance contract would require us to actually own the bond to be valid for a claim, which is not the case for a CDS.
- As mentioned above, there’s no reason for either party to a CDS contract to actually be holding a bond (reference obligation) of the reference entity. CDS can be entered into purely as speculative positions. Even with physical settlement the buyer of protection can just go into the market and buy the appropriate bond at the time of a credit event, and doesn’t need to hold it through the life of the contract.
- CDS contracts are usually not entered into with retail investors. You or I couldn’t actually execute a CDS on our bond position; we don’t have big enough positions to make it worthwhile in general. Hedge funds, pension funds, fund managers and insurance companies tend to be the counterparties to the banks on these contracts (as well as other banks).
- Credit default swaps are usually documented such that a range of bonds can be ‘delivered’ (handed over in physical settlement or used to calculate losses in cash settlement). The text above implied that only one bond was ever relevant. The reference obligation cited in the contract simply defines the type of bond that can be delivered (its seniority). Usually any bond of the same seniority or higher seniority can be delivered. CDS can be traded without any reference obligation being cited: usually this means that any senior unsecured debt can be delivered.
- This is a zero-cost instrument. The two parties to the contract just agree the details up front, and the contract starts without any initial payment being necessary. If you are a seller of protection you just get premium in without having to do anything, which can be attractive.
Summary
In summary, a credit default swap is a contract where one party to the contract pays a small periodic premium to the other, in return for protection against a credit event (financial difficulty) of a known reference entity (company).
This article was written in 2007. Since then there have been a few developments in the credit default swap market. A discussion of these developments can be found in part 2 of this series of articles.
Rich Newman 
I would say just excellent !!! for a developer who know nothing about CDS and eager to understand the same in an hr!! Thank you.
That is an excellent article I wish I had seen when I started working for an investment bank 3 years ago on the application dealing with CDS credit event fees. I’m forwarding this article to my previous colleagues so they have a nice reference.
Thanks
What is the usual rate for CDS protection. I know you stated that it is a percentage of the face value of the bond, but what would be considered standard? Does the “premium” percentage vary with the risk of the bond issuer, or the size of the bond?
Great article above. As you can tell, this is totally foreign to me.
Thanks,
Michael Rytter
Michael
Your question highlighted a bit of a gap in my article. I have amended it to talk about the size of the premium on CDS. See the new sections ‘Size of Premium Payment is Bigger if the Company is More Likely to Default’ and ‘Size of Premium Payment and How it Relates to Bond Prices’ above.
Rich
This article is really well explained with easy words and I’m glad I have learned what are CDS.
My job consists in Lending securities to brokers.
Before maturity date, we have to recall bonds when they are still at brokers side, because it can be very risky for us if brokers keep them too long after maturity getting interests on it!
I just wanted to share with you that when we lend our client’s bonds, brokers pay us a “callateral” (more or less equal to the value of bonds + a marge of risk) in order to prevent us from any financial difficulty.
Daniel (From Belgium)
Bank of New York Mellon Asset servicing, Brussels
i would say many thanks for this, it is something i was looking for to understand the CDS issues,
Excellent explanation for a total newbie.
Really fantastic article, studying finance and the texts always present in such a technical manner!
Thanks
Never before on the net has anyone tried to explain in such simple words any topic. I commend the efforts taken by the author of this article. Wish this article was read by the people who put the US economy in a mess.
Thank you for the explanation Mr. Newman. In light of the current crisis in these derivatives could you explain what happens to these contracts if the protection seller defaults? Would these obligations be eliminated in a bankruptcy restructuring of the protection seller?
An article of very great help. CDS is well expained. Really commendable!
Mr. Newman, thank you very much.
Vasudeva Bhattathiri
Kochi, India.
Best explation I have seen–I have asked my friends in the financial field for an explation of CDS but their eyes crossed, and I saw they were at a loss. Thanks. Now please explain dirivitives. Thanks
Thank you for a straightforward descriptiopn of these things. With reference to Daniel’s comments of March 27, brokers paying collateral rings a bell: specifically the Lehman Brothers bankruptcy. Could you explain how exactly Lehman was engaged in CDSs when the “credit event” (Moodys and S&P lowering Lehman’s credit rating) forced it into bankruptcy?
This was an awesome article and thorough explanation. I have been searching for a concise and readable explantion of credit default swaps. The concept is easy, but this article makes it plain why the market grew so out of control. Much thanks!
A nice article that explains credit default swaps concisely and clearly! I think there maybe one point worth mentioning with respect to the section “Size of Premium Payment is Bigger if the Company is More Likely to Default”. I understand that in times of “financial distress” a protection seller may also demand that the premium to be paid up-front, rather than periodic payments.
Thanks for the lucid explanation of CDS.
It helped me a lot as a layman to understand how a CDS works.
However I do have a question.
In your article you have said at one place “Now suppose the interest rate on a US Government bond is 5% and the interest rate on a General Motors bond of the same maturity is 8%. We’d expect the premium on a credit default swap on General Motors for the same period to be about 3%.” Is this 3% what is known as the spread? Or is 8% the spread?
Thanks!
That was really an excellent article. A must read for newbies (& perhaps ivy league MBA’s who caused the bubble to burst!!)
Excellent article..Well explained
This is an excellent article I would have ever read on CDS.
Rich, excelllent article for its relative simplicity.
With regard to contract premium,you suggest that this would be the difference between the interests paid by the company bond and interest paid by(equivalent) Govt.bond. Would I then be right in saying that normally, one would enter into a CDS contract ONLY where there are signs of distress in the Bond issuing company? (Entering the CDS contract in a company that is looking good makes no sense – the buyer may as well buy the equivalent government bond).
Why there is always upfront payments required for parties involved in CDS trading, if it is like some sort of insurance contract?
wonderful. THnaks a ton
Thanks a lot. was very easy to understand. Looking fwd for more beginners guide for other derivative products
wonderful article!
explained in such a simple manner- it truly justifies its Title “A Beginner’s Guide to Credit Default Swaps”.
Lo and behold,I understand every single word that is being said in this article. Now I know exactly what CDS is. The author has this amazing ability to explain complex issue in simple ways, provides enough details yet does not lose us along the way. If I were to do finance all over again, I would first fire all my previous professors who ramble on with financial jargons but did nothing in making us understand the subject at all.
this is simplyy awesome…i was saying to myself that how easily one can explain 🙂
Best Article! I was looking for good explanation on CDS since Long. Thanks a lot to Author!
Its good article,well explained in very simple terms about CDS.
Thanks a lot!
Sanesh
good article in simple language & easy to understand
Thanks a lot. Very clear and easy to understand.
Great article. Have been processing CDS’s for a few months now and haven’t understood them until now…A Big Thank You…!
Seen an news item in a newspaper, I was just thinking what this CDS means. Google search and your page gave me very clean idea about CDS. Now I can teach others about CDS. Thanks a lot.
Very good article, I just wish more financial jargon could be explained this clearly.
Your name goes on the list of whom to Google when I have a financial question that needs clarification. I’m looking up CDS because I just found out that US Big Banks have exposure through CDSs in the case of PIGS default. And, I must say, I had a chuckle at your statement about bondholders always being first in line to be compensated. But, you wrote in a more innocent time, prior to the GM and Crysler ‘nationalizations’. How could you know? Thanks again. I really enjoyed your article and learned a bunch.
I would still like to know why the name of the premium is Credit Default Swap, when nothing is being ‘swapped’. Simply an insurance premium is being paid and so the name should be Credit Default Fee?
Very informative. But:
I would still like to know why the name of the premium is Credit Default Swap, when nothing is being ‘swapped’. Simply an insurance premium is being paid and so the name should be Credit Default Fee?
Also, more importantly, Bond Seniority doesn’t make sense.
‘If at any stage the money is insufficient to pay the current seniority of bondholder in full, every bondholder gets paid the same percentage of the face value of their bond’. If every bond holder gets paid the same percentage if insufficient money to pay every bond holder in full, then where is the ‘seniority’ in that?
No one gets paid in full and everyone gets only a percentage of what they are due!
John’s questions above made me come back to this article for the first time since Lehmans’ bankruptcy and the subsequent financial crisis. As Karen Deutch pointed out above, my choice of General Motors as an example reference entity was somewhat prophetic given what happened subsequently.
Thanks to everyone who commented above for the positive feedback, and sorry I didn’t answer all your questions. I will answer some of them now.
I also intend to write a brief article describing changes in the CDS markets since this article was written. A couple of comments above are from people confused about upfront fees on CDS (Amitabh Prasad, raymond). These were only rarely paid in 2007 and are much more common now. I will explain why (which is because of the standardization of contracts). I may also discuss my opinion on how much CDS contributed to the crisis as there are some questions about it (Kent).
However, let me start with John’s question as to what is being ‘swapped’ in a credit default swap.
The technical answer is that we have two sets of potential payments in different directions. If I am a protection buyer, the first set is the stream of premium payments I will make to the protection seller until the reference entity defaults. The second set is the single compensation payment that the seller will make to me when the reference entity defaults. Obviously this second set may be empty (no payment will be made if the reference entity doesn’t default).
So the contract is ‘swapping’ a set of premium payments for a compensation payment, even though the compensation payment may not be made at all.
I’ll let you decide whether ‘swapping’ something for something you may or may not get is really a ‘swap’.
There is a more practical reason, I think. This relates to the origins of the market. For banks the taxation and regulatory requirements for CDS contracts were more favourable if they were treated as derivative contracts and not insurance contracts. Clearly CDS have elements of both types of contract. Everyone knew that an ‘interest rate swap’ or a ‘currency swap’ was a derivative contract. So I expect that whoever named it a ‘credit default swap’ did so to emphasize the similarity to those derivative products. It’s a name that says ‘look, I’m obviously a derivative’. This is just my personal opinion, by the way.
John’s second question is about debt seniority. I’ve tried to clarify the appropriate paragraph in the text: let me know if you are still confused.
Ranit asked about what the ‘spread’ was. The answer is that loosely it’s the difference between the US treasury interest rate and the bond interest rate. In my example, that he quotes, it’s the 3%, not the 8%. Again I’ve tried to clarify this in the text.
Finally Raseek Patel asked why you might want to enter into a CDS on a healthy company. I’m assuming he means buying protection, where you would be paying a very small premium for a very small chance that the company would default and you’d get a payout. The answer is that the contract won’t cost much, and apparently healthy companies can become unhealthy quite quickly as we’ve seen in recent years. I work for one that did this.
Where would you find examples or instructions on how to book these transactions into a general ledger?
Awesome Article. it explained CDS very clearly and in detail too. Really Great Learning Resource for Beginners.
However, I have still puzzled about couple of points regarding CDS. If any one can answer that , it would be really great.
Can sum of valuation of all the CDSs for particular Bonds exceed the valuation of that particular Bonds ? Need a example to understand it .
Can total number of CDSs of particular Bonds exceeds the total number of that particular Bonds ? What I am trying to say is it possible that different Hedge Funds create a CDSs for same GM Bonds ?
Is it correct to say that Hedge Funds who have issued the CDS will only loose the money on the CDS in case of Credit Event Only ?
How any party can maintain the short position on the CDS ? I understand Long position is maintained when I am holding that particular CDS.
Thanks,
I’ll answer the four questions you raise in order:
1. Remember that a CDS is just a contract between two counterparties. If it has a value of $1m to one counterparty then it will have a value of -$1m to the other. Net the total valuation of all CDS has to be zero. Having said that it’s theoretically possible for the value of one side (all sold protection say) to be more than the valuation of all associated bonds in existence: the bond is just a reference obligation, it’s not directly involved in the contract at all necessarily (see below).
2. Yes. Using the insurance analogy, it’s possible to take out CDS ‘insurance’ on a bond position you don’t actually own. If several people do this the total face value on the CDS contracts (the amount of bonds being insured) may overall be more than the total face value of all the bonds in existence. Remember that all that’s happening if there’s a default is that the Big Bank above pays us a lot of money: the bonds themselves don’t have to be involved at all. There is a potential problem if the contracts are physically settled and there aren’t enough bonds to actually get hold of to deliver. This could lead to the weird effect of a bond defaulting and its price rising as people struggled to buy it for CDS delivery.
3. In a CDS one party pays a premium until default, the other pays a very large amount but ONLY if there is a default (credit event). So in terms of cash if you’ve sold protection you will only pay if there’s a credit event. However, this answer depends a little on what you mean by ‘lose money’. Organizations like hedge funds will value CDS daily, and report profit based on the current expectations of default etc. So consider what happens if a hedge fund sells protection. It will value the contract (usually at around zero initially). Now suppose the reference entity gets into financial trouble before any payment is made at all. The hedge fund is more likely to have to pay out, so the valuation of the CDS will go down (to some negative number). This is all unrealized loss (no cash has changed hands at all), but I’m sure the hedge fund would regard it as ‘losing money’. It’s like buying a stock at 100 only to see it drop to 50 the next day. You’ve lost money.
4. ‘Long’ and ‘short’ can be confusing with CDS. However, you buy or sell protection, and might consider yourself to be long or short protection respectively after doing so. In this sense, as usual, a short position is just the opposite side of a long position: one party is long and the other short.
Thanks a lot for clarifications.
Regarding #2, since the CDS exchanges hand in unregulated markets, how does it been ensured that the potential problem that you mentioned does not occur. is there any mechanism to check this or we just let the market forces decides how many CDS should be taken on bond position ?
Thanks for the informative introduction. I am a property guy by trade so interesting to learn these things. I have a question however. What happens when the counter-party risk of the CDS (the ‘big bank’) falls below the entity it is ‘insuring’. Surely the more entities these ‘big banks’ insure, the more they cannibalize their own credit rating? Is it the effect of this that we are seeing played out in the crises we are seeing unfold? Would they then re-‘hedge’ this additional risk to themselves by trading CDS on their own covenant? If so, who is the buyer? Sounds like pass the parcel to me….
Actually not all that much happens if the big bank is itself getting into financial trouble. CDS contracts are typically documented to terminate if one party goes into bankruptcy. If we’ve bought protection from the big bank our exposure is thus simply the replacement cost of the contract. This may even be negative if the reference entity is less risky than when the contract started. That is, we can actually benefit because we can replace our insurance with cheaper insurance.
Having said that, no-one is going to buy insurance from an insurer that’s about to go bust without some safeguards. As a result, CDS contracts will often be documented to require collateral that is ringfenced in bankruptcy and can be used to pay for a replacement contract. One of the arguments for moving CDS trading to centralized clearing houses is that it reduces concerns about these issues.
The rest of your questions go to the heart of what a trader at a big bank actually does. Typically a big bank will make a market in CDS and bonds. The idea of market making is that you are prepared to buy or sell almost anything, but then if you trade you try to get rid of the risk with an offsetting trade. You make money by charging a spread to do this. Obviously it isn’t always possible to make a profit by buying something and then immediately selling it, so traders are allowed to run positions within risk limits. However, the overall idea is that the traders overall manage the risk of the trading they are doing so that the bank is not overly exposed. They will be overseen by risk managers to ensure that this is the case.
You ask if this activity ‘cannibalizes’ the bank’s credit rating. The answer is ‘no’, although it can be hard for rating agencies (and investors) to assess the risks associated with trading desks. If our CDS desk is doing its job correctly, and is being monitored by the bank’s internal risk managers correctly, there really shouldn’t be very much risk. Just doing a big CDS trade shouldn’t have any direct effect on credit rating.
As for how vanilla CDS trading of this kind contributed to the financial crisis, the answer is that I don’t think it did really, except in the limited sense that it made the credit markets more liquid and thus contributed to the overall expansion of credit.
What actually happened in the financial crisis was a credit boom and crunch. This was caused by banks and others lending too much money to people and companies and even governments who were never going to be able to repay in a downturn.
It is true that some of the financial instruments the banks used in the credit markets during the boom contributed to too much money being lent, both by and to the wrong people. With some of these instruments it’s not clear that the banks who issued them even understood how much lending exposure they were left with.
However, vanilla CDS were not really one of these instruments in my humble opinion.
How about all the CDS sold by AIG? Didn’t that contribute to the downfall?
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superb introductory read on CDS in 2016…
I found the beginner’s guide to credit default swaps on Rich Newman’s blog to be exceptionally helpful. Your clear explanations and straightforward approach lend simplicity to a complex topic like this one for those new to the concept. The material is comprehensive across various aspects of CDS and the analogies are very relatable . Thank you for providing such valuable educational content.