Credit Default Swap: Definition
A Credit Default Swap (CDS) is a contract whereby a Protection Seller commits, against the payment of a premium, to compensate the buyer (Protection Buyer) in the event of a credit event affecting the solvency of a Reference Entity.
- With the exception of the exchange of the premium, no cash flow occurs until the credit event stipulated at the time of the contract negotiation has occurred.
- It is not necessary to be effectively exposed to risk on the reference entity to enter into a CDS contract.
- The underlying entity need not be in default in order to trigger the guarantee stipulated by the CDS. Depending on the terms of the contract, the credit event may be bankruptcy, or a restructuring, or other events (see below).
The value of the CDS is directly related to the creditworthiness of the reference entity, which is why the CDS is a derivative, more precisely a credit derivative since the underlying is a credit granted to the reference entity.
In addition, apart from the premium, the CDS will only generate financial flows if a credit event related to the underlying entity occurs. The CDS therefore functions as an option, or as an insurance.
CDS contracts are traded over-the-counter. There is no standardisation of contracts, nor organised market. However, following the market explosion and the problems caused by the defaults of large institutions on which there was a huge amount of CDS outstanding, clearing houses for the CDS market have been created. CDSs are therefore part of the "OTC derivatives" (Over The Counter).
With the exception of the premium, which is the subject of a cash transfer, the CDS constitutes a commitment for the seller and an insurance for the buyer. It is therefore recorded off-balance sheet.
Characteristics of CDS
Direction: the direction is understood in relation to protection. The purchase of a CDS entails a commitment to pay the premium and deliver the underlying asset in the event of default by the reference entity and of physical settlement (see below). The sale of a CDS engages to compensate the counterparty of the contract in the event of default by the underlying entity.
Counterparty: since CDS contracts are OTC contracts, the counterparty is always known. It should be noted that the protection buyer who limits his risk in relation to the reference entity, becomes exposed to a risk on the protection seller. This is called the risk of double default (default of the debtor and default of the guarantor of the debtor).
Legal agreement: like any OTC contract, a CDS is traded under a legal agreement that defines all the "non-economic" (i.e. legal and operational) conditions of the contract. The most widely used legal agreement is the one of the ISDA (International Swap and Derivatives Association).
Reference entity: the reference entity is an issuer that can be of any kind: corporate, bank, state...
Underlying asset: The underlying asset is the loan issued by the reference entity. It can be a commercial debt or a bond.
Nominal: this is the total amount guaranteed by the CDS.
Maturity: expiry date of the contract.
Credit event: this is the event or events that affect the creditworthiness of the reference entity and are therefore likely to trigger the settlement of the CDS. They are selected by the parties during contract negotiation among the standard events proposed by the ISDA:
- Obligation acceleration
- Obligation default
- Failure to pay
- Repudiation / moratorium
Premium: amount paid by the protection buyer to the seller.
The premium is expressed as an annual percentage (or basis points) of the
nominal value. It is payable periodically, for example every quarter.
The amounts of premiums (or spreads) paid on a given issuer give an indication of the market's assessment of the quality of that issuer. These amounts are widely shared by market data providers, as are the spreads paid on bond issues.
Settlement method: if the credit event occurs, the contract is settled. The settlement can be:
- Physical: the protection seller pays the buyer the notional amount of the swap, and the buyer delivers to the seller an agreed quantity of the assets issued by the reference entity (receivables, bonds) specified in the contract.
- Cash: the protection seller pays the buyer an amount of cash equal to the notional amount of the swap multiplied by the difference between a reference price for the asset (generally 100%) and the market value of the reference asset at settlement. The buyer is thus exactly compensated for the fall in the market value of the reference asset.
Valuation: the pricing of a CDS consists in determining the amount of the premium that the protection buyer must pay in order to be fully compensated in the event of default by the reference entity. It therefore takes into account the probability of default, the expected recovery rate in the event of default, and of course the life of the CDS. For an example of CDS pricing, see this document.
CDS "nth to default" or "basket CDS" case: in this case the underlying entity is in fact a basket of different entities, or issuers, and the underlying asset is a basket of assets, for example a list of bonds. The execution of the guarantee is subject to the number of defaults occurring on the basket of assets. "First to default" case: the guarantee is triggered as soon as the first credit event occurs on the basket. In a "2nd to default", the first event has no effect, but the second default triggers the settlement of the contract, and so on... As we can imagine, the valuation of this type of contract depends strongly on the correlation between the underlying assets.
Organisation of the CDS Market
As mentioned above, the CDS market is an over-the-counter market. However, there are specialized actors. Some of them have been hit hard, as early as 2008 (see this article).
The most exposed are those who have massively developed a CDS selling activity in recent years. Highly profitable for a long time, this activity generated colossal losses, fatal to some, during the bursting of the credit bubble in 2007-2008.
A central player in the CDS market is ISDA, which offers a widely used master agreement and a definition of credit events. ISDA, together with other organisations, also plays a central role in organising the settlement of contracts during credit events affecting a major player (see financial news...) through an auction mechanism. See this article or this one for more detailed explanations on this subject.
However, the market is being organised, with private actors advancing at a forced march to prevent a future organisation from being imposed on them from above by the regulatory authorities.
The calculation agent is responsible for the valuation of the CDS. This is usually a market maker, and may be the seller of the CDS.
Finally, it should be noted that Credit Default Swaps are very often used in the structuring of structured products such as synthetic CDOs and CDOs (Collaterised Debt Obligations).
Credit Default Swaps Documentation
After reading all the articles below you will be totally familiar with CDS. In accordance with the netiquette, we give you the root address of the site, then the direct address of the selected item.
- The Barbican Consulting webiste offers several well-done dossiers, including this one on CDS.
- The law firm Dechert
provides information on ISDA's
CDS auction settlement procedures.
- Some popularization articles by market players:
- For a more economical and concrete vision:
- See this good article from Time: http://www.time.com/time/business/article/0,8599,1723152,00.html
- The ISDA website