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Credit Default Swap (CDS) market

Page history last edited by Brian D Butler 13 years, 7 months ago

 

 

 

 

 

 

 

Table of Contents 


 

 

 

CDS - definition

 

A credit default swap (CDS) is an instrument to transfer the credit risk of fixed income products .   Read further definition from Wikipedia here

 

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

 

Credit default swaps are the most widely traded credit derivatives product.  Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge, or insure against credit events such as a default on a debt obligation.  Also, credit default swaps can be used to speculate on changes in credit spread.

 

 

 

Pricing: 

if the price is 85 basis points, that means that it costs 83,000 euros to insure 10 million Euros of debt over 5 years.  

 

Examples: 

  • 5-year Spanish CDS is 141 bps while 5-year German CDS is 57.5 bps, a difference of 83.5 basis points. This means it costs $8,350/year more to insure $1 million of Spanish debt vs German debt.
  • A basis point on a credit-default swap contract protecting 10 million euros ($12.9 million) of debt from default for five years is equivalent to 1,000 euros a year.
  • A basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

 

 

 

"Sovereign" Credit Default Swaps market:

 

Credit-default swaps are used for protecting bonds against default, and traders use them to speculate on changes in credit quality. An increase in price suggests deteriorating investor perceptions of credit quality, and a decrease indicates improvement.  The contracts pay the buyer face value in exchange for the underlying securities if a borrower fails to adhere to its debt agreements. A basis point, or 0.01 percentage point, is worth $1,000 on a swap that protects $10 million of debt.

 

 

Sovereign = national (think governments)

 

This is insurance against government defaulting.

 

Long position = buy protection.  

 

Credit-default swaps are derivatives that pay the buyer face value if a borrower -- a country or a company -- defaults. In exchange, the swap seller gets the underlying securities or the cash equivalent. Traders in naked credit-default swaps buy insurance on bonds they don’t own. The contracts trade in over- the-counter deals, leaving each side exposed to the risk their partner will default.  Swaps are private contracts and most aren’t traded through clearinghouses, making it difficult for regulators to police a ban and for politicians to define which trades are purely speculative.  read more from Business Week

 

New York and London dominate swaps trading, and both have resisted greater regulation. '

 

Benefits:

usefull for hedging risk (transferring to others willing to take)

 

"Credit-default swaps are an important market indicator for the health of a country or company, and so-called speculators helped bring Greece’s debt problems to politicians’ attention, forcing them to get their deficit under control, said Hans-Peter Burghof, professor of banking and financial services at the University of Hohenheim in Stuttgart, Germany. After the Greek government announced a reasonable budget plan, the speculation stopped, he said  “You shouldn’t kill the messenger,” Burghof said."

 

 

 

Problems in the market: 

*(see also "criticism of CDS below...)

 

not enough volume, hard to find counterparties to trading, wide bid-offer spreads

 

 

 

Uses

Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.

 

 

Investors can use the information from the CDS markets to better understand the stocks

 

For informed investors, CDS premiums can act as a good barometer of company's health. If investors are not sure about a firm's credit quality they will demand protection thus pushing up CDS spreads on that name in the market. Equity markets will then draw a cue from the credit markets and push down the stock price based on fear of corporate default.

 

 

 

Hedging

 

Credit default swaps can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

 

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million which trades at 200 basis points.  In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) 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 loan back after 5 years from the Risky Corporation.

 

Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario 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 taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond). Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

 

 

Speculation

 

Credit default swaps give a speculator a way to make a large profit from changes in a company's credit quality. A protection seller in a credit default swap effectively has an unfunded exposure to the underlying cash bond or reference entity, with a value equal to the notional amount of the CDS contract.

 

For example, if a company has been having problems, it may be possible to buy the company's outstanding debt (usually bonds) at a discounted price. 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.

 

It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds themselves, the cost to purchase the swap from another party may fluctuate as the perceived credit quality of the underlying company changes. Swap prices typically decline when creditworthiness improves, and rise when it worsens. But these pricing differences are amplified compared to bonds. Therefore someone who believes that a company's credit quality would change could potentially profit much more from investing in swaps than in the underlying bonds (although encountering a greater loss potential).

 

 

CDS to measure risk:

 

Question:  what is a better measure of risk....spreads over German bund? or, sovereign credit default swaps (to measure default risk_? can they be different? where can you go to find this data?

 

Answer (thank you Aaron!):   There are several types of risks. The best measure of CREDIT risk is found in credit default swap spreads. This would be your best indicator of DEFAULT risk because a CDS only prices in the chance of a credit event occurring. If you think Spain has a better chance of defaulting than Germany, like I do, you would expect the CDS trading on Spain to be greater than Germany. It is, 5-year Spanish CDS is 141 bps while 5-year German CDS is 57.5 bps, a difference of 83.5 basis points. This means it costs $8,350/year more to insure $1 million of Spanish debt vs German debt.

 

The difference in CREDIT risk has to show up in the current yields or there would be an arbitrage opportunity. Generic Spanish 5-year debt is trading 106 basis points above German debt. The extra 22.5 basis points probably are due to LIQUIDITY risks, German bunds are more liquid and therefore get a liquidity premium; and maybe more importantly, FINANCING risk. For a leverage player it probably costs more (reflected in a repo rate) to borrow against Spanish debt than German debt. Or borrowing against Spanish debt uses more capital (reflected in larger haircuts).

 

For DEFAULT risk use CDS. 

 

more:  risk

 

 

 

Criticisms of CDS

(see also "problems of market" above)

 

“The hurricane is not more or less likely to hit because more hurricane insurance has been written. In the financial markets this is not true. The more people write financial insurance, the more likely it is that a disaster will happen, because the people who know you have sold the insurance can make it happen.” :  After Wall Street bailed LTCM out, Mr Meriwether quoted his colleague, Victor Haghani, on how other firms had traded against it....source The Economist

 

False impression that markets are less risky than they are

 

Derivatives such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder why indices like the Dow Jones Industrial Average and S&P 500 seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities issued by such companies may retain significant paper value up until almost the very end. Instead of selling, investors can buy "insurance" in the form of derivatives and keep holding their investments. This distorts the value of traditional market indices because the decision to remove a failing company from the index can be made well before the paper value drops to zero. This saves the value of the index.

 

It creates the false impression that the index always rises.

 

The underlying markets, for which the index was developed to reflect value, may be far more unstable than appearances indicate. False appearances of stability allow securities markets to appear far less risky than they really are, encourage less knowledgeable players to speculate on derivatives, and allow broker/dealers, financial journalists and some academics to claim that markets are far better investments for the retail investor than they really are. The overall effect is to reduce the perception of risk even though the risk still exists. The reduced perception, however, reduces risk premiums and encourages shoddy loan practices, and may be the cause of runaway financial bubbles, when irrational exuberance gains traction on the basis of inaccurate information.

 

 

 

Criticism of Derivatives in General

 

Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction."

 

"Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." The same report, however, also states that he uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold and currently sell derivatives with notional amounts in the tens of billions of dollars.

 

 

 

Increase risk & exposure

 

The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name are vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion. In addition to spreading risk, credit derivatives, in this case, also amplify it considerably.

 

Insider information

 

Another major issue is the vast difference in knowledge concerning the creditworthiness of the underlying borrower. Major banks and investment banks, like JP Morgan Chase, Citigroup, Bank of America, Merrill Lynch, Goldman Sachs, Lehman Brothers, etc., are usually the originators of syndicated loans or the underwriters of stock and bonds of the companies in question. Credit swaps are issued, by these same banks, against the credit of those companies. JP Morgan and its cousins have a much better idea whether or not particular borrowers are really at risk of default, because of their relationships with those borrowers. This can be deemed "inside" information, which would be illegal to possess while actively trading in a particular market, in almost any other field of market activity. Yet, within the credit default swap trading community, insider trading is not only a given, but is the fundamental basis upon which the entire structure depends. Indeed, these same major banking institutions also dominate the market for issuance of derivatives, generally.

 

 

Need for Central Clearing Facility:

 

"Clearing Facility"- there is the desire to change the way in which the OTC market in credit default swaps occurs...changing to some form of centralized clearing faclity

 

CDS is at the heart of the Bear Stearns rescue by JP Morgan/ the Fed;  Bear Stearns was recently "rescued" by the federal reserve (and JP Morgan).   Why did they save them?   One big reason is that Bear Stearns was one of the major counterparties at the center of the systemically important $45 trillion Credit Default Swap (CDS) market.  It is for this reason that keeping track of the gross derivatives exposure is as important as netting across counterparties, as the Senior Supervisors Group points out in its recent report “Observations on Risk Management Practices during the Recent Market Turbulence”.  Follow the discussion in: “The Systemic Risk of a Significant Counterparty Default in the CDS Market

 

 

 

 

Regulation:

Last year, U.S. regulators and Congress rejected a proposed ban on buying credit-default swaps without owning the underlying debt.

 

“My own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally,” Geithner told lawmakers on March 26, 2009. “It’s too hard to distinguish what is a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.”

 

But, Trading Is Mobile

“Trading would just migrate to countries where no ban exists,” he said. “If you tell your own banks, ‘I’ll crush you if you trade in other countries,’ you would put your domestic banks at an economic disadvantage to others.”

 

Who is calling for regulation?

Others in the U.S. including hedge-fund billionaire George Soros have called for greater transparency and limits on trading naked swaps. Charles Munger, vice chairman of Berkshire Hathaway Inc. in Omaha, Nebraska, wants an outright ban on trading. Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, repeated calls this week to give regulators the authority to police the market for “fraud, manipulation and other abuses.” read more from Business Week

 

 

Biggest traders:

The world’s five biggest CDS dealers are JPMorgan Chase & Co., Goldman Sachs Group Inc., Morgan Stanley, Deutsche Bank and Barclays Plc, according to a report by Deutsche Bank Research, citing the European Central Bank and filings by the U.S. Securities & Exchange Commission. The measurement is in terms of CDS notional amounts bought and sold.  read more from Business Week

 

 

Recent events:

 

As the credit crisis deepened in 2008, the cost of insuring against national defaults became more expensive.   Its interesting however, the investors could have made lots of money on this trade.  If they bought (long position) sovereign CDS in September 2008, and then sold th position in October 2008, they might have doubled their money.  Thats because the sovereign CDS market is traded like a stock exchange, and if the index moves up, you make money (if you are "long").

 

How is the likelyhood of a default measured?  By looking at the macro fundamentals of the economies.  In response to the 2008 credit crisis, the cost of insuring US sovereing debt against default actually became more expensive than Mc Donalds!  ouch!

 

Its interesting also that Eurozone sovereign CDS rates have been rising, as expected...but that individual countries are rising at different rates.  This means that investors are doubting whether the single will whether this financial storm in one piece.   Will this be the beginning of the end to the Euro monetary union....time will tell...

 

Who trades in the sovereign CDS market?   Normally, it was speculative hedge funds (global macro funds) that would use the sovereign CDS investments as a means of hedging other bets.  Other investors were local banks.  But, with the rise of the credit crisis in 2008, we see many speculators coming into the sovereign CDS market as a means to bet on the relative differences of countries sovereign risk.  If you think Spain is more risky than Japan...make that bet on this market.

 

Related topics from GloboTrends:

 

 

 

 

 

 

For more information:

 

 

See also

 

External links

 

 

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