A Credit Default Swap (CDS) is a derivative financial instrument that effectively provides insurance on a bond. The idea behind them is that the owner of a CDS pays a certain amount per year (interest rate basis points) and if the asset that is backed by the CDS defaults, then the contract owner is paid off with the interest and premiums that would have been paid if the bond did not default.
This is useful as a risk prevention measure because, in exchange for periodic payments, the CDS provider accepts all of the asset's default risk. Common bonds that these derivatives cover are:
- Municipal bonds
- Emerging market bonds
- Mortgage-backed securities
- Corporate debt between two parties
For example, if an investor believes that a corporation is going to default on its debts, they could buy a CDS from an investment bank covering the said corporation's debt instruments.
- The investment bank would charge a certain amount per year in order to offer the insurance. If the investor bought swaps on $10 million worth of corporate bonds and the bank charged 250 basis points for 3 years, the investor would have a maximum risk of $750,000 for a maximum gain of $10 million.
- The maximum risk is calculated as the cost of financing the swap, which is $750,000 (2.5% x $10,000,000 x 3) in this example. Interestingly, the risk is constant (assuming no counterparty risk from the CDS seller) and both maximum and minimum risk are the same.
- The maximum gain is the face value of debt receivable in the future ($10 million). This is due to the fact that in the worst-case scenario, the corporation can default on the entire debt obligation which now is transferred to the CDS provider. In case there is no default at all, there is no gain at all.
- This CDS is profitable to the investor if the corporation defaults on an amount greater than the value of the swap premium, which in this case is $750,000.
CDS: What is it used for?
The three main reasons for using CDS are:
Most CDS transactions require the use of an ISDA Master Agreement, which is an agreement published by the International Swaps and Derivatives Association (ISDA) that outlines the terms of over-the-counter (OTC) derivatives transactions between two parties. It applies not just to the current transaction, but to all future transactions as well.
Originally CDSs were used as an insurance or hedging policy, but due to the fact that the buyer does not have to own the asset in order to buy a default swap on it, they are increasingly used as tools for relatively cheap speculation. The only cost for the buyer of this product would be the fixed premium cost they would have to pay.
Arbitrage is when an investor takes advantage of market mispricing to generate profits. This is typically done by buying an asset from one market and then selling it in another market. The investor depends on a wide asset spread in order to make a profit, or in other words, for there to be a big difference in the prices between the two markets. The main premise of arbitrage is deriving a risk-free profit.
A classic example of arbitrage is when someone buys antiques from a thrift store for a low price then goes to an auction house to sell them for a high price. In this scenario, the person doing the arbitrage depends on there being a big difference between the price from the thrift store and the price of the auction house. If the prices of the two markets were the same, the arbitrageur would make little to no profit. Illustrated below is another very simplified example of an arbitrage:
Let us assume that a person lives close to a grocery as well as a fruit market. On talking to the owners of both places, he finds out that the vegetable market sells apples for $20 a bushel and that the grocery buys bushels at $30 a bushel.
The arbitrage opportunity:
The person can walk over to the fruit market, buy a bushel of apples at $20 a bushel and sell it immediately to the grocery at $30 a bushel with absolutely no risk due by virtue of mispricing. This is exactly what arbitrage is. However, as you probably noticed, such opportunities are very rare and close themselves out very quickly if at all they do exist. In this example, it is only a matter of time before the grocery starts buying from the fruit seller, thereby leaving no opportunity for the person to conduct any kind of arbitrage transaction.
Arbitrage using CDS:
So how does this apply to CDS arbitrage? The most common CDS-related "arbitrage" is the CDS - Cash bond arbitrage. In this trade, an investor buys a bond and then buys a CDS on the bond. For this arbitrage to work, the rate of coupon payment on the bond needs to be higher than the CDS premium rate. Let's illustrate this with an example.
Banana Ltd. has issued bonds with a coupon rate of 10%. An investor is able to negotiate a CDS premium of 6% on the same bonds. In this case, the investor can buy the bonds as well as the CDS and make a profit of 4% (10% - 6%) on a risk-free position as there is no risk of default to the investor (default risk is borne by the CDS seller). This is considered "arbitrage" due to the risk-free nature of the return.
From a big picture sense, hedging is the action one takes to protect themselves from risk. In this case, hedging is the action one party takes to protect themselves against the potential default of a borrower. Illustrated below is an example:
We use a farmer who invests their money into growing wheat to sell for a profit. However, there is risk involved such as drought, excess supply, flood, spoilage, etc.
Hedging through use of a forward contract:
The farmer determines their profit margin but is kept in check by the baker. If priced too high, the baker will go to market for the lowest cost. If priced too low, the farmer will operate at a loss. It's probable that both will use a naive forecast and adjust accordingly once the wheat is harvested.
Instead, the farmer and baker set a price for a future date irrespective of the market. This effectively means that the farmer has fixed their sale price (and therefore his margins) and the baker has fixed their cost price (reducing uncertainty in costing). This mitigation of risk is what is called hedging. The contract involves a particular commodity which details the quantity and quality of the asset and is settled in either cash or physical delivery.
- If there is excess demand and the market price is higher, the baker benefits
- However, if there's excess supply and the price drops, then the farmer benefits instead of losing at market prices
Hedging using a CDS:
So how can a CDS be used to hedge? CDSs are primarily used by investors to protect them from the risk that a debt issuer defaults on their debt security. Let's look at the following example to understand this better.
Investor X holds $10 million in face value of bonds issued by Banana Ltd. There are rumors that Banana Ltd. may not be able to meet its obligation on its borrowings due to a cash flow shortage resulting from a bad year for business. In this case, investor X would approach an investment offering CDS on the bonds they hold, agreeing to pay the required premium in exchange for protection for default. This precisely is how a CDS is primarily used by investors hedging against default risk.
Read more about hedging in this discussion.
A CDS would be useful for a speculative investor because they could use it to make directional bets on the movement on prices without putting up much collateral. One of the key defining characteristics of speculation is uncertainty. Illustrated below is an example:
A wheat farmer can't hedge their crop unless someone assumes their risk and the speculator is that risk-taker. Either by gut instinct, research, or word-of-mouth they act on information that leads them to believe a profit opportunity exists. While the farmer is only interested in fixing their sale price and margin, the speculating counterparty strongly believes and wants the price of wheat to increase, thereby being able to bag a profit on the delivery of wheat. Let's assume that the farmer has agreed to sell a ton of wheat for $200. The speculator is essentially betting that the price of wheat will increase and stands to make a good profit if it does. If the market price of a ton of wheat is $250 at the time of delivery, the speculator makes $50. However, if the price of wheat falls to $180, the speculator loses $20.
Speculation through use of a forward contract:
Speculators can profit by purchasing a contract at a set price and then sell it at higher future spot prices as in the case of a drought. Conversely, they can also short the contract because future spot prices are expected to fall as in the case of a bumper crop.
However, speculators aren't just futures traders. They can be homeowners looking to "flip" houses, index fund investors looking towards retirement, or a small business trying to sell itself but they all have one characteristic. They're looking to purchase an asset with the expectation to sell it for a profit in the future and with the future comes the risk of loss.
Speculation using CDS:
In the same way that speculators enter any other derivative contract without owning the underlying, a speculator in CDS agrees to buy one from an investment bank without owning the underlying bonds. Assume that in the earlier example, investor X didn't hold the underlying bond, but wants to profit from default by Banana Ltd. They can choose to enter into a CDS contract with a bank willing to extend one to them. This is what CDS speculation looks like. X willingly pays the required premium on the CDS contract without holding any of Banana Ltd.'s bonds and will profit heavily if and when they default.
Read more about speculation at this discussion.
Example of a Credit Default Swap
Let's assume that Hedge Fund X (HFX) owns $10 million worth of a five-year bond issued by someone with a risky credit rating, such as The State of New Jersey (NJ). IF HFX feels that NJ may default on its loans, they will buy a CDS from a counterparty, typically a bank.
HFX buys the CDS at a notional (par value) value equal to the bonds it has with a 5-year duration from a seller such as, in this case, Goldman Sachs (GS). According to the terms of the swap, HFX will pay GS a quarterly premium in return for the protection from default. In our example, HFX pays a premium at the rate of 1% per annum of the notional to GS in quarterly payments (0.25% approx at every payment).
Now, over the course of the 5 years, NJ can either not default or default. If NJ does not default, HFX will have paid GS a total of $500,000 for the premium on protection and receives $10 million-plus the periodic interest from NJ on the bonds. In this case, the CDS premium reduces the total return on the bond position, but HFX has effectively eliminated its downside risk of default.
If NJ defaults, HFX stops paying the premium and settles with GS in one of the two ways.
- Physical settlement: where the buyer delivers the defaulted asset to the seller for payment of par value on the contract. HFX would transfer the NJ bonds to GS for $10 million.
- Cash settlement: where the seller pays the buyer the difference between par and the market value on the bond. Assuming a full default on the bonds, GS will pay NJ $10 million without taking ownership of the underlying bonds.
This is the most basic view of a swap and doesn't get into reselling or speculation aspects.
To learn more about this CDS example, refer to this forum.
Real-world examples of a Credit Default Swap
One of the most infamous uses of CDS would be its use and popularity during the 2008 Financial Crisis, which has been documented in the book The Big Short: Inside the Doomsday Machine, and has even been turned into a movie. Furthermore, the role of CDS in the 2008 crisis can be inferred from its market value. At the end of 2007, the value of the CDS market was around $62.2 trillion which reduced by around 2012 to around $25.5 trillion, a decrease of about 60%.
While many bulge bracket investment banks were involved, Lehman Brothers were the most involved with this instrument. So much so that their company was wiped out by the overuse of the CDS. This is primarily due to the fact that as the value of contracts rose, investment banks began using them to cover their debt, and in the case of Lehman Brothers, its $600 billion in debt was covered by $400 billion in CDS, which is nearly two-thirds of their total debt.
As a result of the financial crisis, the United States introduced the Dodd-Frank Regulatory Reform Bill of 2009 as a means to control and regulate the credit default swap market. This new piece of legislation ultimately prohibited banks from undertaking many of the risky practices, such as the risky swaps, that lead to the financial crisis in the first place.
These contracts were also used during the European Sovereign Debt crisis, particularly in Greece. The contract's use became so prolific in this crisis that strategists believed the probability that Greece would default rose to nearly 95% (source: CNN).
**To learn more about this concept and become a master at bonds and fixed income, please check out our Bond Course - Fixed Income (coming soon!).**
- Basis Point (BPS)
- Counterparty Risk
- Fixed Income (FI)
- Investment Bank (IB)
- Interest Rate (IR)