[5 min finance]Credit Default Swap Overview

Quick Facts
◦It was created by Ms. Blythe Masters from J.P. Morgan to hedge risk in early 1990s
◦In early 2000s, investors who used it for speculation dominated the market
◦It worsened the 2007–2008 financial crisis after Lehman Brother filed for bankruptcy
◦Those who don’t want to learn CDS from textbooks can watch the film “The Big Short (2015)”

What is a swap?
An over-the-counter agreement between two companies to exchange cash flows in the future that defines the dates when the cash flows are to be paid and the way in which they are to be calculated.

◦Reference asset: bonds/loans that CDS buyer wants to transfer credit risk
◦Single-name CDS: covers a debt security issued by a single reference entity
◦Notional principal: value of the reference assets that is protected by the CDS contract
◦Physical settlement: CDS seller buys the bonds from CDS buyer for the par value
◦Cash settlement: CDS seller buys the bonds from CDS buyer for a pre-determined price

CDS Benefits
◦Differences between insurance and CDS
— No need to hold the bond to buy a CDS on that bond
— CDS contracts are traded over the counter
◦Hedging credit risk: transfer credit exposure and free up regulatory capital
◦Less cash outlay and more liquidity than investing in the underlying cash bonds
◦Access to maturity exposures not available in the cash market
◦No currency risk for investments in foreign credits

CDS Risk
Higher credit spread →higher risk of the investment →higher cost to protect against default →more likely to default
◦Unregulated before 2009 ( banks used customer deposits; no clearing house was set up)
◦Dodd-Frank Wall Street Reform Act in US(2009) and MiFID II in Europe(2011)
◦Liquidity risk: like other OTC derivatives, margin calls for additional collateral if one or both parties must post collateral
◦Jump risk: unexpected default of reference entity creates a sudden obligation on the seller to pay huge amount of compensation to the buyer
◦Counterparty risk:
— If seller defaults, buyer loses protection and may have to replace the defaulted CDS at a higher cost
— If buyer defaults, seller loses expected revenue and may have to sell the CDS at a lower price

CDS Pricing
◦CDS Spread: a credit spread measured as the difference in returns between a risky investment and an equivalent risk-free investment = bond yield — risk free rate
◦Measured in basis points of the notional value (ex: 567 base points)
◦Example: A CDS spread of 800 bp for a five-year debt means that default insurance for a notional amount of $ 100 costs $8 annually but paid quarterly ($2 per quarter)
Recovery rate : percentage of notional repaid in event of default

CDS spread = probability of default * (1 — Recovery rate)

r = risk-free rate| s = CDS spread| π = probability of default| dt = discount factor at time t C = contingent payment in case of default | q(t) = survival probability at time t

Basic rule: PV(premiums paid by CDS buyer) = PV(payoff received from CDS seller)

Example: for a 1-year CDS, default occurs after 6 months and the accrued premium is paid immediately after a default

PV of the premiums paid by CDS buyer = s * [0.5 * d(0.5 year) * π + d(1 year) * (1- π)]

PV of the payoff received from CDS seller = C * d(0.5 year) * π

Value of a CDS contract for protection buyer in the real world= PV of contingent payments in the case of default — PV of fixed payments for premiums

CDS Valuation
◦Hedge-based valuation by Schönbucher (2003)
— Based on the assumption that CDS contracts with the same cash flows occurring at the same time should have the same price
— CDS price can be estimated simply from a portfolio of assets with the same payoff
— Results are often imprecise

◦Bond yield-based pricing by Hull &White (2000)
— Based on the assumption that a reference entity’s credit risk can be assessed by the price or yield difference between a defaultable bond and a risk-free bond with the same payoffs and maturity
— CDS price is calculated by the discounted cash flow method

◦Non-credit risk factors may impact the yield spread of defaultable bonds

Credit Default Swap Index (CDX)
◦Established and launched in early 2000s, CDX is a highly liquid and completely standardized credit derivative that trades at a very small bid-ask spread à cheaper option for hedging
◦Investors can trade a broad spectrum of credit risk in a liquid market at low costs
◦One of the major tradable indices together with ABX, CMBX, and LCDX
◦Historical data shows a strong positive correlation between VIX and CDX.NA.IG
◦Equal-weighted index comprised of 125 firm. CDX index rolls over every six months, and its 125 names enter and leave the index as appropriate when the rebalance occurs
◦5 indexes: investment grade (IG), high yield (HY), high volatility (HVOL), crossover (XO) and emerging market (EM)
◦Below investment grade indexes have much larger spread

For investors
1. Closely monitor CDX indices, especially CDX.NA.IG
2. Play with the pricing and valuation models before investing any CDS product
3. Understand the potential risk and prepare backups in case of defaults