Finance

Functioning of Credit Default Swaps

Functioning of Credit Default Swaps:

  • A credit default swap (CDS) is a credit derivatives instrument that provides insurance to the buyer [Protection Buyer] against the risk of a default by a particular company [Reference Entity].
  • The fundamental role of credit default swaps is to transfer credit risk between a party wishing to reduce credit risk, often called the protection buyer, risk seller or risk hedger (the party going short the credit), and the party wishing to acquire or hold credit risk, often called the protection seller or risk buyer (the party going long the credit).
  • Each CDS has a notional amount and it requires the buyer to pay a premium called CDS spread.
  • The credit event is binary in nature, i.e. it occurs, or it doesn’t.
  • Typical credit events include (a) a filing for bankruptcy by the third party on whose bond the CDS was issued, (b) any failure by the third party to pay interest on its bonds, and (c) any restructuring of the Debt.

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Structure of Credit Default Swaps

  • A CDS is the exchange of two cash flows: a fee payment [CDS Spread] and a conditional payment that occurs only if certain circumstances are met.
  • More precisely, the CDS will have value for the protection buyer only if these conditions are met, whereas the protection seller will receive the predetermined fee in all scenarios.

A CDS is analogous to a specific type of insurance option in which default of an asset triggers payment

Cash Flows of a single-name CDS

Functioning of Credit Default Swaps

  • If a default occurs, the CDS is activated and terminates with the payment according to the predetermined conditions of the contract.
  • The payment can be 100% of the face value or a percentage of the total (nominal) CDS commitment, depending on the importance of the loss triggered by the credit event.

There are two payment modes:

  • Physical settlement – the protection buyer remits the asset to the protection seller against full face value payment or surrender the underlying asset with the par amount.

Functioning of Credit Default Swaps

Example: On August 15, 2018, two parties enter into a credit default swap. The terms of the contract are a five-year CDS, with the protection buyer paying 120 basis points (bps) annually for protection on a $100 million bond position (referenced asset). The contract’s payment schedule calls for semi‑annual payments, with the physical delivery of the bonds in the event of default. The protection buyer pays $600,000 every six months to the seller beginning on February 15, 2019 [(120 bps × $100 million) ÷ 2] until the end of the contract, or until the credit event (default) occurs. The buyer will receive a payout only if the reference entity defaults (triggering the credit event). If this happens, the protection seller must buy the bonds for $100 million.

  • Cash settlement – the protection buyer retains the asset and receives the difference between face value and recovery value, as established by an independent assessor

Functioning of Credit Default Swaps

If the above example called for cash settlement rather than physical settlement, the recovery value would be determined by an independent assessor using the recovery rate, which is the realizable rate of recovery upon default. If the bonds’ recovery rate is $200 per $1000 of par value (20%) after the default, the cash payout the protection seller must make is $80 million ($100 million– $20 million recovery value).

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Sovereign [Countries] credit default swaps

 

 

  • The above picture represents 5Yr Sovereign Credit Default Spreads which are the most liquid credit default spreads.
  • A CDS spread of 30 bps for the US means it would cost about $23,300 to buy protection on $10,000,000 in US government debt with an implied probability of default of 0.39%. Similarly, a CDS spread of 42 bps for India means it would cost about $227,420 to buy protection on $10,000,000 in Indian government debt with an implied probability of default of 3.79%.

Credit Default Swaps in India:

  • Credit default swaps were introduced into India in 2011 as part of an overall strategy by the RBI to further deepen and widen the corporate bond market as banks and other financial institutions use CDSs to transfer and manage credit risk through these instruments.
  • As with other OTC derivatives in India, there are two types of participants in the CDS market: market makers and users.
  • Market makers are entities permitted to quote both buy and/or sell CDS spreads. They are permitted to buy credit protection without having the underlying bond. Market makers include commercial banks, primary dealers, and non-bank financial companies. Insurance and mutual fund companies are not currently market makers but can become such with the approval of their respective
  • Users are entities permitted to buy CDSs only to hedge the underlying credit risk of holding corporate bonds. Examples of users include listed corporations, insurance companies and mutual funds.
  • The salient features of CDSs in India include that they only are allowed on all listed corporate bonds, rated unlisted corporate bond, cannot be written on securities that have an original maturing of less than one year, be denominated in Rupees, that only plain-vanilla bonds be allowed and that all CDS trades have an RBI regulated entity on at least one side of the trade.

Summary:

  • On the start date, no payments are made by either party; and
  • On periodic interim dates, protection buyer pays to protection seller pre-agreed amounts; and
  • If a Credit Event does not occur, no further payments are made at maturity; or
  • If a Credit Event occurs and physical settlement applies, the transaction shall accelerate and protection buyer shall deliver the Deliverable Obligations (For eg bond) to protection seller against payment of a pre-agreed amount (For eg Par amount of a bond)
  • If a Credit Event occurs and cash settlement applies, the transaction shall accelerate and protection seller shall pay to protection buyer equal to [(Par-recovery value)*notional]

 

Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.

 

 

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