Credit Default Swaps

Introduction to Credit Default Swaps (CDS)

Welcome! If you’ve ever felt like fixed income is a bit dry, Credit Default Swaps (CDS) are where things get exciting. Think of a CDS as an insurance policy for a bond. In this chapter, we will explore how investors use these tools to protect themselves from companies going bust, or even to bet on the health of the economy. By the end of these notes, you’ll understand how they are priced, what triggers a payout, and how professional traders use them in the real world.

1. What is a Credit Default Swaps?

At its simplest, a Credit Default Swap (CDS) is a derivative contract between two parties that transfers the credit risk of a specific "Reference Entity" (usually a corporation or a government) from one party to another.

There are two main players involved:

1. The Protection Buyer: This party wants to hedge against the risk of default. They pay a periodic fee (like an insurance premium) to the seller.
2. The Protection Seller: This party "insures" the debt. They receive the periodic fees but must pay the buyer a large sum if the company defaults.

Analogy: Think of it like car insurance. You (the buyer) pay monthly premiums to the insurance company (the seller). If you don’t crash, the seller keeps the money. If you do crash (a "credit event"), the seller pays for the damage.

Key Terms to Know:

• Reference Entity: The company or government whose debt is being insured. Note: The Reference Entity is not a party to the contract.
• Reference Obligation: The specific bond or debt instrument that the CDS is based on.
• Notional Amount: The total value of the debt being protected.

Quick Review: The Protection Buyer is Short the credit of the company (they profit if things go bad). The Protection Seller is Long the credit of the company (they profit if the company stays healthy).

2. Credit Events: What Triggers a Payout?

A CDS doesn't just pay out because a company's stock price drops. A specific Credit Event must occur. The International Swaps and Derivatives Association (ISDA) defines these events to avoid arguments.

1. Bankruptcy: The company legally declares it cannot pay its debts.
2. Failure to Pay: The company misses a scheduled interest or principal payment.
3. Restructuring: The company forces lenders to change the terms of the debt (e.g., lower interest or longer maturity) because it's in financial trouble. Note: This is more common in Europe than in the US.

Did you know? A "Credit Determinations Committee" actually votes to decide if an event officially counts as a default. This keeps things fair for both sides!

3. Settlement: How Do You Get Paid?

If a credit event occurs, there are two ways the protection seller pays the buyer:

• Physical Settlement: The buyer hands over the actual defaulted bonds to the seller, and the seller pays the buyer the full par value (face value) in cash.
• Cash Settlement: This is the modern standard. The seller pays the buyer the difference between the bond's par value and its current market price after default. This market price is determined via an auction.

The Payout Formula:
\( \text{Payout} = \text{Notional Amount} \times (1 - \text{Recovery Rate}) \)

Example: If you have \$1,000,000 of protection and the bond is worth 30 cents on the dollar after default (30% recovery rate), the seller pays you: \$1,000,000 \times (1 - 0.30) = \$700,000.

Takeaway: Cash settlement is more common because it doesn't require the buyer to actually own the physical bonds to get paid.

4. Pricing and Valuation of CDS

In the "old days," CDS premiums were whatever the two parties agreed on. Today, the system is standardized to make trading easier.

The Standardized Coupon

Instead of custom rates, most CDS contracts use fixed coupons:
• 1% for Investment Grade bonds.
• 5% for High Yield (junk) bonds.

The Upfront Payment

Since the coupon is fixed at 1% or 5%, but the actual risk of a company might be higher or lower, the parties make an Upfront Payment at the start of the contract to bridge the gap.

The Upfront Payment Formula:
\( \text{Upfront Payment} \approx (\text{CDS Spread} - \text{Fixed Coupon}) \times \text{Duration of CDS} \)

• If CDS Spread > Fixed Coupon: The Buyer pays the Seller upfront.
• If CDS Spread < Fixed Coupon: The Seller pays the Buyer upfront.

Mark-to-Market: Profit and Loss

As the credit health of a company changes, the CDS Spread moves. This creates a profit or loss for the holders.
• If credit spreads widen (risk increases): The Protection Buyer profits.
• If credit spreads narrow (risk decreases): The Protection Seller profits.

Memory Trick: Think of the CDS Spread like a "risk thermometer." If the temperature (spread) goes UP, the insurance (CDS) becomes more valuable to the person holding it (the Buyer).

Common Mistake: Don't confuse "Spread" with "Price." In the CDS world, if the spread goes up, the value of the protection goes up for the buyer, but the "price" (from the perspective of a bond holder) has dropped.

5. CDS Strategies

Professional investors don't just use CDS for insurance; they use them to express views on the market.

1. Naked CDS: Buying protection without owning the underlying bond. You are simply betting that the company will default or its credit will worsen.
2. Long/Short Trade: Buying protection on one company and selling it on another. You are betting that Company A's credit will deteriorate relative to Company B's.
3. Curve Trades:
• Flattening Trade: You think the long-term risk will rise faster than short-term risk. You buy long-term protection and sell short-term protection.
• Steepening Trade: You think short-term risk is overpriced. You sell long-term protection and buy short-term protection.
4. Basis Trade: Exploiting the difference in price between a company's actual bond and its CDS contract. In a perfect world, they should be the same, but market inefficiencies often create opportunities.

Quick Summary:
• Expect credit to worsen? Buy Protection (Pay Spread).
• Expect credit to improve? Sell Protection (Receive Spread).

6. CDS Indices

Just like the S&P 500 tracks stocks, CDS indices track groups of companies. The two most famous are:
• CDX: Covers North American and Emerging Market companies.
• iTraxx: Covers European and Asian companies.

These indices are highly liquid, meaning they are very easy to buy and sell. If an investor wants to bet on the entire US economy's credit health, they buy or sell the CDX index rather than picking individual company bonds.

Summary: The "Big Picture"

• CDS is a contract that transfers credit risk.
• Buyers pay a premium; Sellers pay out if a credit event happens.
• Credit Events include Bankruptcy, Failure to Pay, and Restructuring.
• Pricing involves a fixed coupon (1% or 5%) and an upfront payment.
• Profit/Loss is driven by changes in credit spreads over time.
• Indices (CDX/iTraxx) allow for easy trading of broad market credit risk.

Don't worry if the math for upfront payments feels slightly abstract—just remember the relationship: if the company looks riskier (spread rises), the person who bought the protection is making money!