A credit derivative is a contract in which a party (the credit protection seller) promises a payment to another (the credit protection buyer) contingent upon the occurrence of a credit event with respect to a particular entity (the reference entity). A credit event in general refers to an incident that affects the cash flows of a financial instrument (the reference obligation). There is no precise definition, but in practice, it could be filing for bankruptcy, failing to pay, debt repudiation or moratorium. For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.
Why are they traded?
Credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.
Hedging example – ABC Company owns $10 million worth of a five-year bond issued by XYZ Corporation. XYZ company is a risk corporation hence in order to manage the risk of losing money if XYZ defaults on its debt, the ABC company buys a CDS. They pays 1% of 10 million ($100,000) in quarterly instalments. These payments will reduce the overall returns of ABC from the loan to XYZ but it will protect ABC from any loss.
Speculation example – It may be possible to buy the company’s outstanding debt (usually bonds) at a discounted price if the company is having problem repaying its debt. If the company has $1 million worth of bonds outstanding, it might be possible to buy the debt for $900,000 from another party if that party is concerned that the company will not repay its debt. If the company does in fact repay the debt, you would receive the entire $1 million and make a profit of $100,000. Alternatively, one could enter into a credit default swap with the other investor, by selling credit protection and receiving a premium of $100,000. If the company does not default, one would make a profit of $100,000 without having invested anything.
Life cycle events: –
Coupons and upfront fee,
Coupons are paid by the buyer of the CDS trade to the seller every quarter from the inception of the trades.
Types of Credit Derivatives
Single Name – Underlying of the trade is a single company. Example Microsoft.
Index – Underlying of the trade is an Index. Example iTraxx.
Index Tranche
Loan CDS
Loan Index (Cancelable/Non-Cancelable)
ABS SWAP
ABX/CMBX Index
Bespoke/CDO
Option
Running CDS VS Upfront CDS
In the standard credit default swap (CDS), the protection buyer pays for protection by making regular spread payments to the protection seller until the earlier of a credit event or maturity of the contract. We call this a running CDS as the protection payments run throughout the life of the contract. However, when the reference credit is distressed, protection-sellers quote prices on an up-front basis. This means that protection buyers make only a single up-front payment at initiation in return for protection against a credit event (typically these are bankruptcy, failure to pay and restructuring) until the contract maturity date. These contracts are also usually entered into for short maturities, i.e. up to one year.
History
In 1995, J.P. Morgan’s Blythe Masters (a 26-year old Trinity college graduate hired by the bank), developed the first Credit Default Swaps and Collateralized Debt Obligations (CDO). On April 2, 2007, Masters (who by then was the head of J.P. Morgan’s Global Credit Derivatives group), helped introduce Credit Watch to help evaluate credit swaps among other financial instruments.
Terms of a typical CDS contract
A CDS contract is typically documented under a confirmation referencing the 2003 Credit Derivatives Definitions as published by the International Swaps and Derivatives Association. The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations, and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.
CDS confirmations also specify the credit events that will trigger a credit event and give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include ‘restructuring’ as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to pick up circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings. This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco’s restructuring in 2000 led to the credit event’s removal from North American high yield trades.
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.
Quotes of a CDS contract
Sellers of CDS contracts will give a par quote (see par value) for a given reference entity, seniority, maturity and restructuring e.g. a seller of CDS contracts may quote the premium on a 5 year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. The par premium is calculated so that the contract has zero present value on the effective date. This is because the expected value of protection payments is exactly equal and opposite to the expected value of the fee payments. The most important factor affecting the cost of protection provided by a CDS is the credit quality (often proxied by the credit rating) of the reference obligation. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher.
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 minutiae 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 Z-spreads or asset swap spreads is called the basis.
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