Credit Default Swap

It is a derivative financial instrument that effectively provides insurance on a bond

Author: Austin Anderson
Austin Anderson
Austin Anderson
Consulting | Data Analysis

Austin has been working with Ernst & Young for over four years, starting as a senior consultant before being promoted to a manager. At EY, he focuses on strategy, process and operations improvement, and business transformation consulting services focused on health provider, payer, and public health organizations. Austin specializes in the health industry but supports clients across multiple industries.

Austin has a Bachelor of Science in Engineering and a Masters of Business Administration in Strategy, Management and Organization, both from the University of Michigan.

Reviewed By: Hassan Saab
Hassan Saab
Hassan Saab
Investment Banking | Corporate Finance

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside M&A, restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a BS from the University of Pennsylvania in Economics.

Last Updated:October 1, 2023

What Is Credit Default Swap (CDS)?

A Credit Default Swap (CDS) provides the purchaser insurance should the underlying bond issuer default on their debts. If the bond issuer defaults (says they won’t pay the rest of the bond back), the seller of the CDS will have to pay the insured amount back to the purchaser of the swap.

The purchaser generally pays a fee (spread) based on a percentage of the amount insured. The percentage is measured in basis points, with one basis point equalling 0.01%.

For example, someone insuring $10 million with a 500 basis point (or 5%) premium would have to pay $500,000 annually for the insurance that a CDS provides. 

The higher the premium, the riskier the bond, i.e., the lower the creditworthiness.

Should an event affect the loan, the seller of the contract either buys the bond at the insured value or pays the difference between the bond owner sells it for and the insured value.

Both provide the same outcome, the value that was insured being delivered.

A high spread means a high premium which means high risk on the bond and vice versa.

Key Takeaways

  • Credit Default Swaps (CDS) offer insurance against bond defaults. The buyer pays a fee based on the insured amount's risk level.
  • CDS involves three parties: bond owner, buyer, and seller. It's a derivative contract based on differing opinions about default risk.
  • They hedge risk, speculate on credit changes, and exploit market gaps. High premiums indicate higher default risk.
  • Created for bank hedging, CDSs developed a riskier secondary market due to pooling and anonymity.
  • CDSs played key roles in the 2008 financial crisis and European debt crisis, revealing market vulnerabilities and economic turmoil.

How do credit default swaps (CDSs) work

A CDS contract is one form of a derivative contract, a swap. A derivative contract entails any kind of financial contract with reliance on an underlying asset, group of underlying assets, etc.

A swap contract is a subsection of derivative contracts. It involves exchanging the cash flows or value from two assets owned by two different parties.

It says that Party A, the bond owner, will receive a payout from Party B should the lender default on the loan, i.e., not pay back the bond.

In exchange for this insurance, Party B receives a premium. For a CDS contract to be sold, there must be three parties involved:

  • The issuer of the debt, the borrower
  • The purchaser of the debt and the CDS contract, the lender
  • The seller of the CDS contract

The borrower is uninvolved in the CDS, only offering the underlying asset. As a result, the lender believes that the borrower might default on their loan.

Lastly, the seller believes that the lender will not default on their loan and the payments they will receive outweigh the risk involved.

Like almost every trade in the securities markets, a transaction requires two contradicting opinions on what will happen with the underlying asset.

When are CDSs Used?

While these financial contracts seem like complicated instruments, there are some straightforward uses. First, these contracts are generally used by larger financial institutions, with minimal interaction by commercial investors in the market.

The uses for CDSs are, but are not limited to:

1. Hedging

This is defined as an investment that reduces the risk involved in another investment.

Generally, hedges reduce your possible profit but decrease your possible losses, making them an attractive option for those heavily invested in a single asset that might be facing short-term turbulence.

In the case of a CDS, the asset is a bond. Due to unforeseen circumstances, the bond owner may feel that the issuer may be at a more significant risk of defaulting on their payments.

Should this occur, the bond would become worthless, only receiving payments from someone given the job of paying out debts.

Sometimes all debt is repaid (which is extremely unlikely), sometimes part of the debt is repaid  (the most common), and sometimes no debt is repaid.

No matter what occurs, a CDS will ensure that the bond purchaser will receive some form of payout from the swap seller should the bond issuer default.

The exact payment agreements range heavily as these contracts are sold over-the-counter (OTC), meaning not on a public exchange, and they are heavily catered to each agreement.

2. Speculation

An investor can enter a position on a CDS if they feel it is too expensive or cheap for the conditions of the underlying asset.

An investor who purchases a CDS believes that the bond issuer’s creditworthiness is likely to fall, leading to an increase in the price of the insurance, or this case, a CDS.

Alternatively, an investor who believes that the creditworthiness of a bond issuer will rise will sell CDSs in anticipation of lower prices for the “insurance” in the future. Briefly, the CDS purchaser shortens the bond issuer’s creditworthiness while the seller is long.
  
3. Arbitrage

This is buying a security in one market with the expectation of immediately selling in a separate market to exploit a small price gap.

This is one of the reasons that security listed on multiple exchanges maintains the same price across them all relative to exchange rates.

When there is negative news about a company, the stock price is likely to fall, and the likelihood that they will be able to pay their debts will generally decrease, even if only slightly.

In comparison, positive news relating to a company will drive up the share price and lead to a better outlook on its ability to repay its debt.

Again, this effect might be very small. However, no matter the size of the change, savvy investors can profit from the movements in CDSs due to the market lag.

Overall, these swaps are seen as one of the measurements of creditworthiness for a particular borrower.

If CDS premiums seem high related to historical premiums, the risk of default is likely higher than usual, most likely related to some event internal or external to the company. This effect also works and vice versa.

When were cDSs invented?

Created in the mid-1990s by Blythe Masters of JP Morgan, CDSs were intended as a means for banks to hedge against bond risk.

There are also strict legal requirements for banks to hold a certain amount of liquid assets like cash about their non-liquid assets. These requirements decrease the likelihood of banks defaulting.

A CDS decreases the required amount of liquid assets a bank must maintain. This is attractive as the less liquid an asset is, the larger return on investment is achieved.

These two purposes were achieved through the CDS, but slowly a shift occurred.

A secondary market for CDSs emerged, leading to sellers of these swaps having questionable ability to pay up should a default occur.

Next, the underlying loan became hard to find as these swaps began getting pooled into one more considerable asset. This fact ultimately led, in part, to the financial collapse of 2008, but that will be covered later.

A company’s ability to pay a debt is easier to understand if financial statements are available. However, these statements can’t be reviewed if the underlying company is unknown.

Without the ability to see these statements, it’s near impossible to understand what you’re buying or selling, creating unknown risks.

Lastly, the purchasers of these swaps changed. No longer were they the owners of the underlying assets. Instead, investors started using these financial instruments to essentially bet on occurrences relating to the creditworthiness of a bond issuer.

These three facts together lead to a CDS market with anonymity, both for the swap seller and the bond issuer, ultimately making the secondary market for these swaps riskier.    

Examples of credit default swaps

Now that we have a firm grasp on what credit default swaps are, what they’re used for, who uses them, and how they were created, we can look at major events throughout history greatly affected by these swaps.

Since these are only recent developments, we have to look at the immediate past to see their effects.

While bond derivatives may seem to be a wholly unexciting and low-profit space, they are instead the contrary.

Billions were made in the housing crash of 2008 that bankrupted some of the largest banks in the world partly because of credit default swaps.

With lenders constantly defaulting on their loans and huge credit recoveries, money will always be made in the market.

To see how you could take advantage of this interesting financial tool, we will look at past events in which CDSs have been significant.

The 2008 Financial Crisis

Mortgages were being issued in the form of adjustable-rate mortgages. While seemingly payable when interest rates are low, many who took out these mortgages couldn’t pay their dues should interest rates rise significantly.

When exactly that happened, thousands defaulted on their mortgages. This was a significant issue for the major banks.

For many years before these defaults, banks had sold enormous quantities of credit default swaps on seemingly AAA mortgages. As a result, the mortgages were essentially touted as the best of the best, i.e., the least likely to default.

Many mortgages were pooled together to get these assets to a size worthwhile for the largest banks. But unfortunately, pooling all these “AAA” mortgages together meant that no one bothered to look at the individual mortgages, which were subprime.

Before the housing market crash in 2008, surprisingly, credit default swaps were the most significant asset pool in the world.

$22 trillion was invested into the stock market, $7.1 trillion in mortgage debt and $4.4 trillion was issued in U.S. Treasury bonds. Overall this adds to $33.5 trillion. In comparison, over $45 trillion was invested into credit default swaps.

While not all of these were credit default swaps on mortgages, this helps give an idea of how many banks were taking part in this market.

Ultimately, thousands started to default on their mortgages as interest rates rose, and the banks selling these credit default swaps were on the hook.

These derivatives, along with a litany of other issues caused by the housing collapse, led to huge debts for banks.

Many banks had to receive bailouts, and some shut down entirely, including Lehman Brothers and Bear Stearns.

Famous investors like Michael Burry, Greg Lippmann, and Jamie Mai were shown making over a billion combined in the book and film “The Big Short.”

These investors had discovered how exposed the large banks were to the defaulting of these subprime mortgages, ultimately achieving incredible gains by shorting the financial sector, i.e., betting that the financial sector would go down.

Lehman Brothers collapsed, and the sellers of credit default swaps on Lehman Brothers debt, i.e., other large banks, were forced to pay out vast sums of money, creating a domino effect.

One of the main reasons this all occurred was the unregulated nature of these over-the-counter swaps and a handful of other financial instruments that many banks were heavily invested in without fully understanding.

After the crash, banks became wary of lending, leading to further economic pains and a slower recovery.

European Sovereign Debt Crisis

The 2008 financial crisis caused international turmoil, with the effect on Greece being particularly awful, reaching sovereign debt of 113% of GDP.

Nations in the eurozone (countries using the euro) began to spin out of control as banking institutions failed, governments racked up substantial debt balances, and creditors lost confidence in the euro zone’s ability to pay off immense debts.

This led to increasing interest rates, further increasing debt, causing a feedback loop.

CDS spreads strongly indicate which countries were the worst affected and which were making it out relatively unscathed, with interest rates also acting as a signal. 

There were massive spreads for distressed countries like Portugal and Greece, with premiums reaching almost 16%.

For comparison, relatively unaffected countries like Poland, Hungary, and Russia had premiums of around 2%.

This eight-fold difference in premium demonstrates how little confidence investors had in countries deeply affected by the financial crisis.

Credit Default Swaps (CDSs) FAQs

Researched and Authored by James Fazeli-Sinaki

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