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CDS - definition
A credit default swap (CDS) is an instrument to transfer the credit risk of fixed income products . Read further definition from Wikipedia here
Credit default swaps are the most widely traded credit derivatives product. Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation. Also, credit default swaps can be used to speculate on changes in credit spread.
In the news recently:
"Clearing Facility"- there is the desire to change the way in which the OTC market in credit default swaps occurs...changing to some form of centralized clearing faclity
CDS is at the heart of the Bear Stearns rescue by JP Morgan/ the Fed; Bear Stearns was recently "rescued" by the federal reserve (and JP Morgan). Why did they save them? One big reason is that Bear Stearns was one of the major counterparties at the center of the systemically important $45 trillion Credit Default Swap (CDS) market. It is for this reason that keeping track of the gross derivatives exposure is as important as netting across counterparties, as the Senior Supervisors Group points out in its recent report “Observations on Risk Management Practices during the Recent Market Turbulence”. Follow the discussion in: “The Systemic Risk of a Significant Counterparty Default in the CDS Market”
"Sovereign" Credit Default Swaps market:
Sovereign = national (think governments)
This is insurance against government defaulting.
Long position = buy protection.
As the credit crisis deepened in 2008, the cost of insuring against national defaults became more expensive. Its interesting however, the investors could have made lots of money on this trade. If they bought (long position) sovereign CDS in September 2008, and then sold th position in October 2008, they might have doubled their money. Thats because the sovereign CDS market is traded like a stock exchange, and if the index moves up, you make money (if you are "long").
How is the likelyhood of a default measured? By looking at the macro fundamentals of the economies. In response to the 2008 credit crisis, the cost of insuring US sovereing debt against default actually became more expensive than Mc Donalds! ouch!
Its interesting also that Eurozone sovereign CDS rates have been rising, as expected...but that individual countries are rising at different rates. This means that investors are doubting whether the single will whether this financial storm in one piece. Will this be the beginning of the end to the Euro monetary union....time will tell...
Who trades in the sovereign CDS market? Normally, it was speculative hedge funds (global macro funds) that would use the sovereign CDS investments as a means of hedging other bets. Other investors were local banks. But, with the rise of the credit crisis in 2008, we see many speculators coming into the sovereign CDS market as a means to bet on the relative differences of countries sovereign risk. If you think Spain is more risky than Japan...make that bet on this market.
Pricing: if the price is 85 basis points, that means that it costs 83,000 euros to insure 10 million Euros of debt over 5 years.
Problems in the market: not enough volume, hard to find counterparties to trading, wide bid-offer spreads
Related topics from KookyPlan:
Uses
Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.
Investors can use the information from the CDS markets to better understand the stocks
For informed investors, CDS premiums can act as a good barometer of company's health. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default.
Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.
For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million which trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank. If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation.
Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario is eliminated.
If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.
Speculation
Credit default swaps give a speculator a way to make a large profit from changes in a company's credit quality. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity, with a value equal to the notional amount of the CDS contract.
For example, if a company has been having problems, it may be possible to buy the company's outstanding debt (usually bonds) at a discounted price. If the company has $1 million worth of bonds outstanding, it might be possible to buy the debt for $900,000 from another party if that party is concerned that the company will not repay its debt. If the company does in fact repay the debt, you would receive the entire $1 million and make a profit of $100,000.
Alternatively, one could enter into a credit default swap with the other investor, by selling credit protection and receiving a premium of $100,000. If the company does not default, one would make a profit of $100,000 without having invested anything.
It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds themselves, the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. Swap prices typically decline when creditworthiness improves, and rise when it worsens. But these pricing differences are amplified compared to bonds. Therefore someone who believes that a company's credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds (although encountering a greater loss potential).
Criticisms
Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction."
"Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars.
Increase risk & exposure
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably.
Insider information
Another major issue is the vast difference in knowledge concerning the creditworthiness of the underlying borrower. Major banks and investment banks, like JP Morgan Chase, Citigroup, Bank of America, Merrill Lynch, Goldman Sachs, Lehman Brothers, etc., are usually the originators of syndicated loans or the underwriters of stock and bonds of the companies in question. Credit swaps are issued, by these same banks, against the credit of those companies. JP Morgan and its cousins have a much better idea whether or not particular borrowers are really at risk of default, because of their relationships with those borrowers. This can be deemed "inside" information, which would be illegal to possess while actively trading in a particular market, in almost any other field of market activity. Yet, within the credit default swap trading community, insider trading is not only a given, but is the fundamental basis upon which the entire structure depends. Indeed, these same major banking institutions also dominate the market for issuance of derivatives, generally.
False impression that markets are less risky than they are
Derivatives such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder why indices like the Dow Jones Industrial Average and S&P 500 seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities issued by such companies may retain significant paper value up until almost the very end. Instead of selling, investors can buy "insurance" in the form of derivatives and keep holding their investments. This distorts the value of traditional market indices because the decision to remove a failing company from the index can be made well before the paper value drops to zero. This saves the value of the index. It creates the false impression that the index always rises. The underlying markets, for which the index was developed to reflect value, may be far more unstable than appearances indicate. False appearances of stability allow securities markets to appear far less risky than they really are, encourage less knowledgeable players to speculate on derivatives, and allow broker/dealers, financial journalists and some academics to claim that markets are far better investments for the retail investor than they really are. The overall effect is to reduce the perception of risk even though the risk still exists. The reduced perception, however, reduces risk premiums and encourages shoddy loan practices, and may be the cause of runaway financial bubbles, when irrational exuberance gains traction on the basis of inaccurate information.
For more information:
See also
External links
- Explanatory Diagram from the New York Times
- 2003 ISDA Credit Derivatives Template
- BIS - Regular Publications
- OCC - Quarterly Derivatives Fact Sheet
- A Beginner's Guide to Credit Derivatives - Noel Vaillant, Nomura International
- Documenting credit default swaps on asset backed securities, Edmund Parker and Jamila Piracci, Mayer, Brown, Rowe & Maw, Euromoney Handbooks.
- A billion-dollar game for bond managers
- Hull, J. C. and A. White, Valuing Credit Default Swaps I: No Counterparty Default Risk
- Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations
- Elton et al, Explaining the rate spread on corporate bonds
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