Credit default swap (CDS) was first introduced by Blythe Masters, the youngest woman to become managing director at J.P. Morgan. The first CDS was purchased by J.P. Morgan in the face of a $5 billion threat due to the Exxon Valdez oil spill.
With $30 trillion in traded volume in 2022, CDS is one of the most used financial derivatives in the banking sector. However, it’s often criticized for the lack of regulations and its contributions to the 2008 crisis.
By definition, CDS is a financial derivative that allows lenders (typically a bank) to minimize losses (defaults) through a contract with another investor.
In general, ongoing premium payments are made by the lender to ensure reimbursement of the agreed amount upon default.
However, the definitions aren’t good enough to understand CDS. Let’s discuss CDS like we’re 5.
How CDSs Work
Say you (Lender Larry) loan someone $100 and charge a simple interest of 10% for it to be repaid in a year. Your borrower (Borrower Bob) is expected to pay you back $110 after the said term.
However, being as skeptical as you are, you aren’t sure about getting repaid. Therefore, you offer an outsider (Outsider Oslo) to accept a quarterly premium of $2, totaling $8 to reimburse the loan amount in case of a default.
As expected, after 9 months, Bob loses his job and pays you $80 out of the $100. As promised, Oslo reimburses the remaining $20 and stops receiving the premiums.
As Larry, you receive your full payment by paying just $6 to Outsider Oslo. While you lose money in this case as Outsider Oslo, not every loan is defaulted and reimbursed.
Typically, CDSs are described as financial insurance. The CDS buyer pays the premium to the CDS seller who guarantees the repayments.
Parties involved in a CDS
Generally, five parties are involved in a CDS contract.
The institution or individual that purchases the protection. A CDS buyer is obligated to pay premiums to the CDS seller.
The CDS seller sells the protection in exchange for assuming the risk of a credit event. In most cases, hedge funds, banks, and insurance companies take the risk of being a CDS seller.
They receive payments in periodic premiums from the buyer.
The entity whose credit risk is being speculated in the CDS contract. This can be anyone from corporations to countries.
Reference obligation is the financial instrument that determines the payout in case of a credit event. You can think of it as a weighing scale.
Just as a scale can be used to determine the value of a product, the reference obligations (bonds, loans, ABS, CDO) can be used to define the value of the payout needed.
Clearinghouse is the mediator that oversees the whole CDS contract. The clearinghouse helps institutions find common ground and facilitates a resolution between the parties through collateral and contract transparency.
ICE Clear Credit and LCH Clearnet are two prominent CDS clearing services.
How premiums are determined
Discussing CDS premium calculations is beyond the scope of the article. However, in between the upfront payments and CDS spread, there are a few key factors that determine the premiums of CDS contracts.
As expected, the creditworthiness of the reference entity (borrower) is the major contributing factor to how CDS premiums are calculated. CDS spread, expressed in basis points (bps), are the measure of the creditworthiness of that entity.
1 basis point typically equals 0.01%. For example, if CDS spread on a reference entity is 400 bps, the associated interest rate would be 4.00%.
Duration of the CDS also contributes to the premiums payable to the CDS seller (or protection seller) by the CDS buyer (Protection buyer). Typically, durations are calculated in quarters.
Supply and Demand
If the demand for protection or CDS for a particular entity is high, the premiums will also be higher. In easier words, the higher the risk, the higher the price.
Market volatility and economic downturns may also contribute to the premium amounts. If any industry is facing high volatility during a quarter, the CDS premiums may also increase.
CDS Premium Formula
Two formulas are used to calculate upfront payments and premiums. But, let’s discuss the variables first.
CDS Spread: A percentage determined for the reference entity. Spread can vary depending on the credit risk.
CDS Coupon: The pre-fixed percentage that usually doesn’t change during the lifetime of the contract.
Duration: Duration of the loan or bond.
Protection leg: The total value of contingent payment promised by the CDS seller to the buyer in case of credit events.
Premium leg: Total value of payments made by the CDS buyer to the seller.
Notional amount: The principal lending amount.
Now, coming to the formulas:
Upfront payment = (Protection leg - premium leg)
Premium [%] = (CDS spread - CDS coupon) * Duration
Assume that the CDS spread on a reference entity is 400 basis points (4.00%) and the notional amount of the CDS contract is $10 million.
Also, assume that the CDS coupon rate is 100 basis points (1.00%) per year, payable quarterly.
The annual cost of CDS protection would be 3.00% (400 bps - 100 bps).
Therefore, the protection buyer would pay an annual premium of $300,000 ($10 million x 3.00%) to the protection seller for the life of the contract.
Types of credit events
A credit event is the trigger of the CDS contract. In a CDS contract, several credit events relating to the reference entity may be mentioned to enforce the CDS payout.
A few of them may include:
In the most common use case, if the reference entity files for bankruptcy, the CDS contracts are made operational.
Failure to pay
This credit event occurs when the reference entity fails to make a scheduled payment, although a single missed payment may not trigger the contract.
In case of debt repudiation, debt moratorium, debt conversion, debt subordination, or any changes to the debt obligations, the CDS contract may be enforced or become obsolete.
This credit event occurs when the reference entity’s debt becomes due and payable before its scheduled maturity date.
This occurs when the reference entity defaults on its debt obligations. For example, if the CDS buyer is unable to pay the premiums.
The Bottom Line
Despite the criticism and risks associated with Credit Default Swap (CDS) contracts, the uses often outweigh the drawbacks. In this article, I’ve discussed the mechanism of CDS, the calculation of premiums, and a few credit events.
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