A quick guide to credit default swaps
Market Growth
The credit derivative market has been growing rapidly. The first
transactions were initiated in the mid 1990s. In 2000 the market
was estimated to be USD 0.9 trillion in size, by 2004 this figure had
grown to USD 8.4 trillion. Estimates at the end of 2005 are for a
market of USD 12 trillion. This growth may sound enormous but it
should be put into context. The credit derivative market constitutes
approximately 1% of derivative contracts traded by financial
institutions.
So why the interest in credit derivatives?
Because it has been reported that financial institutions are making
substantial profits from trading credit derivatives. And at the same
time there have been concerns about how well credit derivative
transactions are managed. Regulators in particular have taken
interest in this growing market.
Anecdotal evidence would suggest that in some banks, credit
derivatives constitute the main growth for traded products. And in
these institutions credit transactions may account for 25%-50% of
trading profits. There is no doubt that for some, credit has become
a major source of income, (and risk).
What can you do with credit derivatives?
Credit derivatives can be used for several purposes. Here are some
of their main uses:
1. Risk management & capital reduction: Credit
derivatives can be used for hedging specific credit
exposures, freeing up credit lines and reducing capital
usage. Multiple credit exposures typically found in
investment portfolios and on bank balance sheets can be
hedged using collateralised debt obligations. This may
lead to regulatory capital relief.
2. Investment: Credit derivatives can allow investors to
increase credit exposures in order to obtain a return for
the risks they take. There are many strategies that can
be adopted. Some institutions simply sell credit protection
in order to earn premium income. Credit derivatives also
offer relative value strategies, leveraged trades and
exposures to portfolios and indices.
3. Trading: Credit trading falls into two broad categories.
First there is proprietary trading this includes outright
long / short strategies and relative value trades. For the
proprietary trader credit derivatives offer leverage.
Second there is profit to be made from supplying
liquidity. The market maker gains bid-offer spreads.
4. Structured products: Credit derivative markets now
offer a whole series of structured credit trades. Whilst
some of these trades are complex they do one thing-
they provide traders and investors with tailor made risk
exposures. (Whether the trades are “fair-value” is
another question).
5. Miscellaneous uses: These include hedging credit
spread risks before issuance, hedging receivable risks
and tax arbitrage.
Some of the concerns that face banks when trading credit products
remain.
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Two issues have been highlighted by regulators:
1. How will banks deal with a large number of transactions
subsequent to a credit event?
2. Can trade processing be accelerated in order to clear up
outstanding transactions between counterparties?
Users of credit products also need to consider what they are doing
with them. In a relatively benign credit environment increasing
leverage using credit derivatives will prove profitable. But in the
long run this is not risk free. Only a genuine, well thought out
business strategy will offer firms the best chances of success.
Users of complex or structured credit products should also ask
whether they fully understand the nature of the risk they are
entering into.
Many buyers of structured products including credit linked notes
and asset backed transactions cannot accurately price or value the
transactions. These products are sold on the basis of caveat
emptor. Many of the valuation models rely on the user to input
variables. Assumptions can cause significant errors.
How credit default swaps, (CDS), work
CDS are the vanilla or basic credit trading product. They allow credit
risk to be bought and sold. Furthermore in order to trade CDS you
do not need to own the underlying asset or credit exposure. Assets
like bonds contain both credit risk and market risk so bonds are not
“pure” credit trades. However by using CDS you can buy and sell
credit risk in isolation. The underlying credit risk is known as the
Reference Entity.
The CDS is a bilateral derivative contract; (the word “swap” is
somewhat misleading. With CDS although the documentation
refers to floating payments this is not Libor or Euribor, cash flows
that people normally associate with an interest rate swap).
One party is the default protection buyer. This party pays a regular
fixed premium to the other party who is the default protection
seller.
The premium is expressed in basis points and is normally paid on a
quarterly actual 360 basis. The payment dates may co-inside with
the IMM futures payment dates. The dollar amount of the premium
is calculated using the nominal or effective amount of the
transaction.
Premium Q/Act 360
Protection Protection
buyer seller
The protection buyer pays a regular
premium to the protection seller
The size of the premium is dependent on the credit risk, (a defined
Reference Entity), and maturity of the CDS that is traded. The
greater the perceived credit risk the higher will be the premium.
 The CDS will have a maturity date. This is normally in the 3, 5, 7 or
10 year range. If there is no credit event the fixed premium will
continue to be paid by the buyer to the seller until the maturity
date. If there is a Credit Event the trade is settled and the premium
stops being paid.
The floating payment is only triggered or paid if there is a credit
event relating to the reference entity.
What does that mean?
If there is a credit event the CDS terminates. The fixed leg ceases
and there is cash or physical settlement on the floating side of the
trade. (Depending on the documentation that has been agreed the
protection buyer may have to pay the accrued interest up to the
date of default).
Deliverable
Protection Protection
buyer seller
Par value
If a Credit Event arises then
settlement occurs
Credit events
What constitutes a credit event must be clearly defined. This is why
ISDA produces standard documentation for these transactions. It
helps avoid confusion. So when the counterparties enter the trade
they must decide what credit events they wish to include.
Credit events that are frequently used are bankruptcy, failure to
pay and restructuring, (all of these have specific definitions). It is
also normal to have reference to publicly available information in
order to demonstrate that a Credit Event has occurred.
The Reference Obligation
To clarify things further trades include a Reference Obligation.
Normally this would be a senior unsecured bond issued by the
Reference Entity. The Reference Obligation does not need to have
a maturity equal to the CDS; frequently the reference asset has a
maturity that is a little longer.
The Reference Obligation serves the purpose of defining the
seniority of debt on which a credit event can be observed. It also
determines the seniority of the debt that can be delivered should
there be a credit event.
Settlement after a credit event
Depending on the documentation, CDS can be physically settled or
cash settled.
With physical settlement the protection buyer delivers actual
securities, (these must be Deliverable Obligations of the Reference
Entity), to the protection seller.
The seller then pays the buyer a sum of money equal to the
notional or effective amount of the transaction, (par).
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There will however be a number of restrictions related to the
maturity and debt seniority. (Most CDS require senior unsecured
debt as the deliverable).
Nevertheless the protection buyer will deliver the cheapest asset
that is available for delivery and is in this sense long a delivery
option.
Once the seller receives the asset they have a choice. They can sell
it at the prevailing market price or alternatively participate in any
debt workout.
With cash settlement a dealer poll is taken. Dealers are asked the
price at which the Reference Obligation is trading. An average price
is then calculated, (this process may vary with the documentation,
the dealer poll can be an average price on a particular day rather
than an average over a number of days). The cash settlement
amount is then calculated.
For example, suppose the average price is 40%; the amount paid
by the protection seller to the protection buyer would be 100%-
40% = 60%. On a trade of $10m this would be $6m. The
protection buyer normally pays the seller the accrued premium on
the CDS from the last payment date to the credit event date.
Cash settlement can have certain advantages. When the number of
outstanding CDS trades exceeds the amount of deliverables cash
settlement can help. It reduces the possibility that the price of the
deliverable instrument can rise due to artificial supply and demand
conditions.
It is absolutely essential to have CDS trades properly documented.
This means that you need to take legal opinion on the contract you
are entering into.
CDS are the building blocks
The CDS is therefore the basic credit product. It can be used to
take on or hedge credit exposures. It can be used to facilitate more
sophisticated trades. For example first to default swaps, where the
credit protection seller receives a premium for selling protection on
a basket of credits. If any one of these experiences a credit event
the swap is triggered. But the potential loss for the seller is limited.
If a credit event occurs in the basket the swap terminates. The
seller is not at risk to further credit events from the entities in the
basket at a later date.
Credit linked notes and synthetic collateralised debt obligations also
make use of CDS. These structured products use CDS to transfer
credit exposures. With credit linked notes the CDS is used to add
additional credit risk to a traditional medium term note issue. With
debt obligations CDS are used in order to obtain credit exposure
that is then subject to the credit tranching process.
William Webster
Barbican Consulting Limited
wwebster@barbicanconsulting.co.uk
00 44 (0)20 79209128
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