Sovereign CDS - Payment & Pricing

Can someone explain CDS payments. For example:

Say I own $10,000,000 in Italian 5-Yr Bonds. For protection (via a CDS) I would have to pay $376,600 ( I'm confused about the payment if my 5-yr bond expires in 3 months and I still want protection. $376,600 is the price for the full 5 years (60 months) so does protection cost $6276.67 a month and for 3 months would be 18,830? Is that how it works or is there more pricing complexity (time flow of money, and so forth)?

Also regarding the hedge do some investors buy a CDS even if the insurance will cause a loss on the overall bond position.... perhaps to eliminate tail risk?

Lastly, say a country is auctioning bonds for the first time. How are the first swap prices established? If it's not exchange-traded would we ever see the swap deal prices?

A CDS is a derivative much like an option. If you need protection for a specific period of time you buy the CDS when you buy your bonds and sell the CDS when your bonds mature. You have risk in the price change of the CDS over the time period.

CDS contracts are general losers, just like any other insurance. Most people lose money on their life insurance but they buy it for the piece of mind. Same general principal for CDS.

Swap prices are set by large banks / insurance companies. They will price them based on perceived default risk. Obviously they can be mispriced (see AIG).

Also, "default" for the purpose of CDS payments is determined by the ISDA. They are under quite a bit of political pressure at the moment to prevent sovereign CDS contracts from paying out. As such, many investors currently question whether CDS contracts are adequate protection for sovereign bond positions.

Caveat: not a trader / expert and this is off the top of my head.

"I'm confused about the payment if my 5-yr bond expires in 3 months and I still want protection. $376,600 is the price for the full 5 years (60 months) so does protection cost $6276.67 a month and for 3 months would be 18,830?"

Assuming that the payments vary linearly with respect to time is probably not the way to go given that bond default probabilities are not themselves linear. However this chart for the implied default probability of Italian bonds is pretty close if you just want to ballpark it.

I'm at a loss concerning illiniPride's comment about selling a CDS after the bonds mature... what is a CDS worth when there is nothing left for it to insure its owner against (i.e., the default of the bonds)?

Best Response

CDS is a separate contract that you can buy without owning the underlying bond position. Lets use a house as an analogy: You buy a house and you buy insurance to protect against a fire. Now imagine if you don't lose your insurance protection when you sell the house. Theoretically, you would stand to profit if a house you did not owned burned down. This is how CDS contracts work and is at the center of the political maelstrom surrounding them.

Speculators who anticipate a sovereign's credit-worthiness being challenged in the future can buy up CDS contracts when it is relatively inexpensive to do so. Then they wait for the issuers of the contracts to freak out as the probability of a sovereign default increases. The issuers can't handle the tail risk of having to pay out $10mm on an instrument that made maybe $500k selling. Remember, they are all banks and insurers with regulators and capital requirements. Sell them back to the issuers at a massive markup = profit.

This was a massive international trade that worked out for the hedgies.

^ Thanks illiniPride & personofcolour

To clarify, I meant buying insurance on a 5-yr bond that is set to expire in, say, June 2012. So I've held this bond for a long time and just want to insure against some catastrophe. Do I just pay 3/60 of the contract worth... 3 months worth?

Of course if the bond already expired/matured then there's no point in buying insurance against it.

There's def a lot of political pressure on the CDS market. For one, the terms of default can be subjective, especially if done OTC. Secondly, should you really be able to buy insurance (in millions of dollars) on something you don't really own? Derivatives in notational terms are worth trillions of dollars so I don't know if speculation is a good idea (may cause systemic risk) for the more complicated ones. Of course it provides liquidity but that may be the job of the IBs. I'm also not sure if they are settled in cash through clearing houses at the end of every day such as other common products do. .

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