Credit default swaps

A bank has lent €10 million to a car-parts maker and worries about the loan. It cannot easily sell the loan, and it does not want to upset its customer. Instead, it can pay someone else a yearly fee to take the default risk. That is a credit default swap.

A credit default swapA contract in which one party pays a regular fee and the other pays out if a named borrower defaults. (CDS) has two sides. The protection buyerThe side that pays the premium and is paid if a credit event happens. It is short the credit risk. pays a regular premium. The protection sellerThe side that receives the premium and pays out after a credit event. It takes on the credit risk. collects it and promises to cover the loss if a named borrower, the reference entityThe borrower whose default triggers the CDS, such as a company or a government., defaults. The premium is quoted as a yearly spreadThe yearly premium, in basis points of the notional. 100 basis points = 1%. in basis points of the notional and usually paid quarterly.

It works much like insurance on a bond, with two differences. You do not need to own the bond to buy protection, and the contract trades between financial firms like any other OTC derivative. A buyer with no bonds, a nakedBuying CDS protection without owning the bonds or loans of the reference entity. buyer, is simply betting that the borrower's credit will get worse.

Step through the life of a credit event:

Standard terms. Since 2009, most single-name CDS trade with standard terms: a fixed coupon (for example 100 or 500 basis points a year), paid on standard quarterly dates, with an upfront payment that makes up the difference between that coupon and the market spread. The idea is the same as here; the fixed coupons make contracts easier to net and clear.

A signal and a risk. CDS spreads are watched as a live price of default risk, often moving faster than credit ratings (L1.4.07). But a CDS carries a risk of its own: the seller must be able to pay. Defaults tend to arrive together in a crisis, just when sellers are weakest. L1.7.12 shows what happened when one huge seller could not pay.

For notional $N$, a spread $s$ (as a decimal, a year) and a recovery rate $R$:

A rough link between the spread and the chance of default, often called the credit triangle, follows from making the expected premium equal the expected payout over one year:

Here PD is the yearly chance of default the market is pricing. It is only a rule of thumb: it ignores discounting and the extra compensation sellers ask for bearing risk.

A 5-year CDS on €10m. Choose the spread, the recovery rate and the quarter of the credit event (slide to the end for no default). Watch how a small stream of premiums turns into one large payment.

A bank buys 5-year protection on a car-parts maker, notional €10,000,000, at 150 basis points a year, paid quarterly. Each quarter counts as a quarter of a year. Two years and a quarter in, just after its 9th premium, the company files for bankruptcy. The auction sets recovery at 40%.

Under the Basel framework, a bank that buys eligible CDS protection on a loan can reduce the capital it holds against it, by treating the exposure as if it were to the protection seller (L4.2). After 2008, standard index CDS between financial firms were made subject to central clearing in the US and the EU, and the EU's Short Selling Regulation banned naked CDS on EU government debt from November 2012.

• In a CDS the buyer pays a regular premium and the seller pays the loss if the reference entity has a credit event.
• Premium = spread × notional, usually paid quarterly. Payout = notional × (1 − recovery).
• A Determinations Committee decides whether a credit event happened, and an auction fixes the recovery price.
• The spread is a market price of default risk: roughly PD × (1 − R).
• Protection is only as good as the seller, and sellers are weakest when defaults come together.

Credit default swap

A contract in which one party pays a regular fee and the other pays out if a named borrower defaults.

Protection buyer

The side that pays the premium and is paid if a credit event happens. It is short the credit risk.

Protection seller

The side that receives the premium and pays out after a credit event. It takes on the credit risk.

Reference entity

The borrower whose default triggers the CDS, such as a company or a government.

CDS spread

The yearly premium, in basis points of the notional. 100 basis points = 1%.

Credit event

A default event defined in the contract: usually bankruptcy, failure to pay, and in some contracts restructuring.

Determinations Committee

An ISDA committee of dealers and investors that decides whether a credit event has happened.

Auction

A process run after a credit event to fix one market price for the defaulted bonds, used to settle all contracts.

Recovery rate

The share of face value a lender gets back after a default. Written R.

Naked CDS

Buying CDS protection without owning the bonds or loans of the reference entity.