Credit Default Swap
Nagendra Pratap
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default or on the occurrence of a specified credit event (for example bankruptcy or restructuring). Credit Default Swaps can be bought by any (relatively sophisticated) investor; it is not necessary for the buyer to own the underlying credit instrument.[5]
As an example, imagine that an investor buys a CDS from ABC Bank, where the reference entity is XYZ Corp. The investor will make regular payments to ABC Bank, and if XYZ Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-off payment from ABC Bank and the CDS contract is terminated. If the investor actually owns XYZ Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing XYZ Corp debt, without actually owning any XYZ Corp debt. This may be done for speculative purposes, to bet against the solvency of XYZ Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of XYZ.
If the reference entity (XYZ Corp) defaults, one of two things can happen:
- Either the investor delivers a defaulted asset to ABC Bank for a payment of the par value. This is known as physical settlement.
- Or ABC Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if XYZ Corp defaults, there is usually some recovery; i.e., not all your money will be lost.) This is known as cash settlement.[citation needed]
The price, or spread, of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of XYZ Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from ABC Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires, or until XYZ Corp defaults.
All things being equal, a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening.
[edit]Uses
Like most financial derivatives, credit default swaps can be used by investors for speculation, hedging and arbitrage.
[edit]Speculation
Credit default swaps allow investors to speculate on changes in an entity's credit quality, since generally CDS spreads will increase as credit-worthiness declines, and decline as credit-worthiness increases. Therefore an investor might buy CDS protection on a company in order to speculate that a company is about to default. Alternatively, an investor might sell protection if they think that a company is not going to default.
For example, a hedge fund believes that XYZ Corp will soon default on its debt. Therefore it buys $10 million worth of CDS protection for 2 years from ABC Bank, with XYZ Corp as the reference entity, at a spread of 500 basis points (=5%) per annum.
- If XYZ Corp does indeed default after, say, one year, then the hedge fund will have paid $500,000 to ABC Bank, but will then receive $10 million (assuming zero recovery rate, and that ABC Bank has the liquidity to cover the loss), thereby making a tidy profit. ABC Bank, and its investors, will incur a $9.5 million loss unless the bank has somehow offset the position before the default.
- However, if XYZ Corp does not default, then the CDS contract will run for 2 years, and the hedge fund will have ended up paying $1 million, without any return, thereby making a loss.
Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to lock in its gains or losses. For example:
- After 1 year, the market now considers XYZ Corp more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of protection for 1 year to ABC Bank at this higher rate. Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000 (so long as XYZ Corp does not default during the second year).
- In another scenario, after one year the market now considers XYZ much less likely to default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge may choose to sell $10 million worth of protection for 1 year to ABC Bank at this lower spread. Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000 (so long as XYZ Corp does not default during the second year). This loss is smaller than the $1 million loss that would have occurred if the second transaction had not been entered into.
Transactions such as these do not even have to be entered into over the long-term. If XYZ Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.
[edit]Hedging
Credit default swaps are often used to manage the credit risk (ie the risk of default) which arises from holding debt. Typically, the holder of, for example, a corporate bond may hedge their exposure by entering into a CDS contract as the buyer of protection. If the bond goes into default, the proceeds from the CDS contract will cancel out the losses on the underlying bond.
For example, a pension fund owns $10 million of a five-year bond issued by Risky Corp. In order to manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) per annum 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 back after 5 years from Risky Corp. Though the protection payments totalling $1 million reduce investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the bond 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 physical or cash settlement - see above). The pension fund still loses the $600,000 it has paid over three years, but without the CDS contract it would have lost the entire $10 million.
(Note that the pension fund now has counterparty risk with Derivative Bank; if the bank is in financial difficulties it may not be able to refund the full $10 million to the pension fund.)
[edit]Arbitrage
Capital Structure Arbitrage is an example of an arbitrage strategy which utilises CDS transactions.[6] This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; ie if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.e. mis-pricings between a company's debt and equity. An arbitrageur will attempt to exploit the spread between a company's CDS and its equity in certain situations. For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity.
An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a leveraged buyout (LBO). Frequently this will lead to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium.
Another common arbitrage strategy aims to exploit the fact that the swap adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as specific settlement differences, shortages in a particular underlying instrument, and the existence of buyers constrained from buying exotic derivatives. The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades can aim to exploit any differences to make risk-free profits.
--With Regards
Nagendra Pratap