The credit default swap (CDS) is the cornerstone of credit derivatives market. A credit default swap is a swap contract in which protection buyer (buyer of CDS) makes a series of payments over the maturity of CDS to the protection seller & in exchange receives a payment which is contingent on the happening of default by third party (reference entity). In short, it is a credit derivative contract between two parties in order to exchange the credit risk of an issuer (reference entity). The underlying (reference) asset can be bond or loan of any corporation known as reference entity. The reference entity is not a party to the contract. Reference entity refers to the party on which protection is written. The protection buyer makes quarterly premium payments (spreads) to the protection seller. This premium is usually some percent of notional value of CDS contract, expressed in basis points. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash, with the settlement choice determined upfront when entering into the contract. Most CDSs have maturities between one to ten years. Five years is the most typical maturity. Maturity of credit default swaps need not be the same as that of reference asset.
As an example, imagine that an investor buys a credit default swap from ABC-Bank, where the reference entity is XYZ Corp. The investor is the buyer of protection & will make regular payments to ABC-Bank which is the seller of protection. If XYZ Corp. defaults on its debt, the investor will receive a one-time payment from ABC-Bank, and the CDS contract is terminated. A default is referred to as a “credit event” and includes events such as failure to pay, restructuring, bankruptcy, debt moratorium and debt repudiation. If XYZ Corp. does not default then ABC-Bank pockets the premium payments & stands to lose nothing.
A credit event triggers a contingent payment on a credit default swap. Credit events are defined in the 2003 ISDA Credit Derivatives definitions and include the following:
- Bankruptcy: includes insolvency, appointment of administrators/liquidators, and creditor arrangements.
- Failure to pay: payment failure on one or more obligations after expiration of any applicable grace period; typically subject to a materiality threshold (e.g., US$1million for North American CDS contracts).
- Restructuring: refers to a change in the agreement between the reference entity and the holders of an obligation (such agreement was not previously provided for under the terms of that obligation) due to the deterioration in creditworthiness or financial condition to the reference entity with respect to; reduction of interest or principal, postponement of payment of interest or principal change of currency (other than to a “Permitted Currency”).
- Repudiation/moratorium: authorized government authority (or reference entity) repudiates or imposes moratorium and failure to pay or restructuring occurs.
- Obligation acceleration: one or more obligations due and payable as a result of the occurrence of a default or other condition or event described, other than a failure to make any required payment.
For US high grade markets, bankruptcy, failure to pay, and modified restructuring are the standard credit events. Modified restructuring is a version of the restructuring credit event where the instruments eligible for delivery are restricted. European CDS contracts generally use Modified Modified Restructuring (MMR), which is similar to modified restructuring, except that it allows a slightly larger range of deliverable obligations in the case of a restructuring event. In the US high yield markets, only bankruptcy and failure to pay are standard. Of the above credit events, bankruptcy does not apply to sovereign reference entities. In addition, repudiation and obligation acceleration are generally only used for emerging market reference entities. (Credit: JP Morgan Credit Derivatives Handbook – December 2006.)
Settlement of Credit Default Swaps
Settlement arises when the credit event take place. The first step taken after a credit event occurs is a delivery of a “Credit Event Notice” either by the protection buyer or the seller. The settlement can take place in any of the two ways namely physical settlement or cash settlement.
- Physical Settlement: In a physical settlement, the protection seller buys the distressed loan or bond from the protection buyer at par. Here the bond or loan purchased by the seller of protection is called the “deliverable obligation.” Physical settlement is the most common form of settlement in the CDS market, and normally takes place within 30 days after the credit event. Thus, in case of physical settlement, there is a transfer of the reference obligation to the protection seller upon events of default, and thereafter, the recovery of the defaulted asset is done by the protection seller, with the hope that he might be able to cover some of his losses if the recovered amount exceeds the market value as might have been estimated in case of a cash settlement.
- Cash Settlement: In case of cash settlement, the compensation amount is paid by the protection seller to the protection buyer, and the reference asset continues to stay with the protection buyer. The payment from the seller of protection to the protection buyer is determined as the difference between the notional of the CDS and the final value of the reference obligation for the same notional. Cash settlement is less common because obtaining the quotes for the distressed reference credit often turns out to be difficult. A cash settlement typically occurs no later than five business days after the credit event.
A credit default swap contract has been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if the reference entity defaults. However, there are a number of differences between credit default swap and insurance, namely, buyer of a credit default swap does not need to own the security & also the buyer does not even have to suffer a loss from the default event as he gets compensation from protection seller. Typically, there is no insurable interest.
It is possible & increasingly easier to close credit default swap before its maturity to monetize market value of the position. Typically, unwinding a credit default swap position requires agreement by both parties to the contract regarding market value of the position.
Uses and Benefits of Credit Default Swaps
- Effective tool for hedging against changes in Credit Spreads: Default swaps are dynamic, market-sensitive products whose mark-to-market performance is closely related to changes in credit spreads. As a result, they are an effective tool for hedging (or for assuming exposure to) changes in credit spread as well as default risk.
- Ability to create custom maturity products: An investor wants a three-year maturity and duration exposure to an issuer that has only 2-year and 10-year securities outstanding. Selling a three-year default Swap on the 10-year security can create the required exposure. In effect, the investor will have taken on the credit risk for the duration of the swap, i.e. 3 years.
- Management of concentration of credit risk within credit portfolios: An investor who owns a portfolio of credits can alter the concentration risk of their portfolio by buying or selling credit risk on different names and varying maturities by using credit default swaps.
- Management of credit limits: For banks that have loans or transactions with counter-parties that require further funding but are constrained because of internal or regulatory credit limits, credit default swaps can allow the bank to reduce the credit exposure to that counter-party without damaging the business relationship.