Credit Default Swap
What is Credit Default Swap?
A credit default swap is a contract in which the buyer pays a periodic fee and the seller pays out if a named borrower defaults or hits a defined credit event.
The buyer pays a running premium, quoted as a spread in basis points per year on a notional amount, and the seller agrees to make the buyer whole if a credit event hits the reference borrower. Because the buyer need not own the underlying bond, the contract works equally well as a hedge and as a directional bet that a borrower's credit is deteriorating, which is why outstanding notional on one issuer can exceed that issuer's debt. Spreads therefore act as a live market price of default risk, and they typically widen before rating agencies move. Settlement after a credit event is normally by auction: the seller pays notional minus the market value of the defaulted debt, so the payout is the loss rather than the whole face amount. Risk is transferred rather than destroyed, and it concentrates in the sellers, so a buyer who feels hedged is really holding counterparty risk, which is what central clearing and collateral posting were introduced to contain.
Credit Default Swap: a worked example
A fund buys 10 million dollars of protection on a company at a spread of 300 basis points, or 3 percent. The annual premium is 0.03 x 10,000,000 = 300,000 dollars, usually paid as 75,000 dollars a quarter. The company then defaults and the auction values its bonds at 40 cents on the dollar, so the seller pays 10,000,000 x (1 - 0.40) = 6,000,000 dollars, not the full 10 million. Running the spread backwards with the same 40 percent recovery gives an implied default probability of 0.03 / (1 - 0.40) = 0.05, about 5 percent a year.
The mistake students make with credit default swap
Students treat buying protection as removing the risk. It replaces default risk on the borrower with counterparty risk on the seller, and the hedge is only as good as that seller's ability to pay in precisely the conditions that trigger payouts, which is when many borrowers default at once. The second error is expecting the seller to hand over the full notional. The payout is notional minus the recovery value set at auction, so on a 10 million contract with 40 percent recovery the seller pays 6 million, not 10 million.
Credit Default Swap questions
Is a credit default swap the same thing as insurance?
It behaves like insurance in that a premium buys a payout on a bad event, but two differences matter. Insurance normally requires an insurable interest, while a credit default swap can be bought by someone holding none of the referenced debt, which turns it into a pure bet. Insurers must also hold reserves against expected claims, and swap sellers historically did not, which is how one seller could write far more protection than it could ever pay.
What does a widening CDS spread tell you?
A widening spread means the market is charging more per year to insure the same borrower, so it judges default more likely or recovery worse. Because the contracts trade continuously, spreads move faster than credit ratings and are watched as an early signal of stress at a company or a government. A spread moving from 100 to 400 basis points quadruples the annual cost of protection on the same notional.
What is a naked credit default swap?
A naked credit default swap is protection bought by someone who does not hold the underlying debt, so there is nothing to hedge and the position is a straight bet that the borrower's credit will worsen. Supporters say it adds liquidity and price information about credit risk; critics say it lets traders profit from, and possibly hasten, a borrower's distress. The European Union restricted uncovered swaps on the debt of its member governments for that reason.
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