Credit Default Swaps (CDS)

A credit default swap (CDS) is a contract that transfers the credit risk of a borrower from one party to another. The protection buyer pays a regular premium; in return, the protection seller pays out if the reference borrower suffers a credit event such as default or bankruptcy. A CDS works like insurance on a bond, except that buyers do not need to own the bond. CDS became infamous during the 2008 financial crisis, but they remain a major tool for hedging and trading credit risk.

How a CDS works#

After a credit event, the seller compensates the buyer for the loss: roughly the notional amount times (1 minus the recovery rate), usually determined through an industry auction of the defaulted bonds.

Spreads and upfront payments#

Modern CDS contracts use standard coupons (for example 100 or 500 basis points a year), with an upfront payment to adjust for the difference between the standard coupon and the market spread. If the market spread is 250 basis points on a contract with a 100 basis point coupon, the buyer pays an upfront amount roughly equal to the present value of the extra 150 basis points a year.

What CDS spreads tell you#

CDS spreads give a market based estimate of default risk:

annual default probability ≈ CDS spread / (1 - recovery rate)

A spread of 300 basis points with 40% recovery implies roughly a 5% annual default probability under risk neutral assumptions. See Default Probability and Recovery Rate.

Credit events#

Standard credit events, defined by ISDA documentation, include:

• Bankruptcy.
• Failure to pay after any grace period.
• Restructuring (for some contracts, such as many European and sovereign CDS).
• Obligation acceleration or repudiation (mainly for sovereigns).

Regional committees of dealers and investors decide whether a credit event has occurred.

Uses of CDS#

CDS and the 2008 crisis#

AIG sold protection on hundreds of billions of dollars of mortgage linked securities without enough capital to pay. When those securities fell, AIG faced massive collateral calls and needed a government rescue of about $182 billion in commitments. Meanwhile, investors who bought CDS on mortgage securities, as depicted in accounts of the crisis, profited enormously. See The 2008 Financial Crisis.

Reforms#

After the crisis, regulators required central clearing for standardised index CDS and many single name contracts, imposed margin requirements and trade reporting, and standardised contract terms (the 2009 "Big Bang" and "Small Bang" protocols). See Clearing Houses and Central Counterparties.

Risks#

• Counterparty risk: the seller may fail to pay, as AIG nearly did.
• Jump risk for sellers: large losses arrive suddenly at default.
• Basis risk: CDS and bond prices can diverge.
• Liquidity: many single name CDS are thinly traded.
• Documentation disputes over what counts as a credit event.

Frequently asked questions#

What is a credit default swap?#

A contract in which the protection buyer pays periodic premiums and the seller pays out if a reference borrower defaults or has another credit event.

Do you need to own the bond to buy CDS?#

No. Buying CDS without owning the bond, sometimes called naked CDS, is allowed in most markets, though EU rules restrict naked sovereign CDS.

What role did CDS play in 2008?#

Large sellers of protection, notably AIG, could not cover losses on mortgage linked CDS, contributing to the crisis and requiring government intervention.

Next, learn how default risk is estimated in Default Probability and Recovery Rate.