Credit Default Swap (CDS) Basics

Purpose/Function of CDS Contracts To offer protection against the possibility of default on debt payments. The entity buying protection pays a periodic fee (like a premium) for a fixed amount of time. In return, the entity selling protection will pay the face value of the debt in the event of default.

Credit Default Swap Hedging Periodic Fee CDS Bank Lending Firm ABC Payment If Default Occurs Bank must decide whether to retain or sell risk away Loan Pmts Loan Principal ???? Borrowing Firm XYZ

Possible Outcomes Borrower doesn’t default (CDS Bank keeps fees). Borrower defaults and physical settlement takes place. Here, CDS Bank pays the Face Value and receives the bond (hopes for recovery value). Borrower defaults and cash settlement takes place. Here, CDS Bank pays the difference between the Face Value and the Market Value of the bond. Insured keeps bond.

Credit Default Swap Speculation Periodic Fee CDS Bank Speculating Firm ABC Payment If Default Occurs No direct relationship any longer (no “hedge”) ???? Borrowing Firm XYZ CDS Contract written on the credit worthiness of this firm.

Speculation What was the largest driver of the original fee amount for the CDS? Probability of Default What if the credit worthiness of the borrower worsens or strengthens? What happens to the value of the existing CDS contract?

Speculation Example: Suppose that a firm enters into a CDS contract based on IBM’s credit worthiness for 5 years. They agree to pay $500,000 per year for the right to receive $10,000,000 if default occurs. 2 years later, IBM hasn’t defaulted, but its credit worthiness has weakened. What would this do to the value of the contract in this example? Result: Value of the contract goes up. It would cost more than $500,000 on a new contract, given current weakening of credit worthiness.

Speculation Example: Suppose that a firm enters into a CDS contract based on IBM’s credit worthiness for 5 years. They agree to pay $500,000 per year for the right to receive $10,000,000 if default occurs. 2 years later, IBM hasn’t defaulted, and its credit worthiness has strengthened. What would this do to the value of the contract in this example? Result: Value of the contract goes down. It would cost less than $500,000 on a new contract, given the increase in credit worthiness.

Can Speculation in CDS markets affect equity markets? Suppose that you are a net seller of protection based on IBM debt obligations. You receive a fee so long as IBM does not default. If they do, then you have to make a lump sum payment for the face value of debt and fee payments cease. How can you hedge this position with equity? Short the equity of the stock