Shane Kaiser

Credit Default Swaps A credit default swap (CDS) is an over-the-counter credit derivative contract between two counterparties that was originally implemented to transfer credit-risk The risk of default is transferred from the holder of the debt security to the seller of the swap. Originally used by big banks as insurance against loans exposure, but has since grown to be used for things like making a profit on speculation

Credit Default Swaps Two parties: protection buyer and protection seller The protection buyer purchases a CDS from the protection seller by making periodic payments (typically either semiannually or quarterly), called a CDS premium, to the protection seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. Protection buyers typically buy $10 million in protection with a maturity period of 5 years.

History Source: International Swaps and Derivatives Association (ISDA)

Types of Credit Default Swaps

Single Name Default Swap The simplest and most common type of CDS Only one reference entity that can be any borrower, but is usually one of a few hundred widely traded companies Commonly used by big banks to free up capital Currently used by many hedge funds, because not much capital is required to purchase a swap

Portfolio Default Swaps Nearly the same as Single Name Default Swaps, but reference around 50 to 100 (or more) underlying entities Mostly all Portfolio Default Swaps have been replaced by index default swaps

Index Default Swaps Unlike a regular credit default swap, an index default swap (or CDX) is a completely standardized credit security, there for Index Default Swaps can be more liquid and trade at a smaller bid-ask spread Makes it cheaper to hedge a portfolio with a CDX than it would be to buy many single CDS

Pricing/Payout

Pricing Every underlying is give a certain amount of basis points (each representing.01%) These basis points are dependent upon the stability/riskiness of the underlying credit The riskier the underlying, the higher the basis points will be. Reflect markets perception of the risk of default over the risk free rate, almost like a percentage chance of how likely the underlying will default before maturity

Pricing - Example A CDS spread for Corporation A is 40 basis points Thus a protection buyer buying $10 million in protection must pay the protection seller $40,000 annually ($10 million * 0.4%) till maturity or a credit default of the underlying occurs. Payments are typically made semiannually with a maturity of 5 years, thus in this case the buyer will be paying the seller $20,000 each quarter for the next 5 years (assuming no credit event occurs) The buyer would have lost $200,000 in this event

Payout In the event of a credit event (eg, bankruptcy): The protection buyer no longer needs to pay the seller (in this example it was $20,000 every six months) The two parties wait 30 days after the credit event, and see where the senior debt of the underlying is trading on that 30 th day After those 30 days, the protection seller pays back the protection buyer the amount of protection purchased times, one minus the current price of the debt is trading

Payout -Example If the protection buyer purchased $10 million in protection, and the underlying defaults, the payout seller waits 30 days after the default occurs to determine how much to pay the protected buyer. If the senior debt is trading at $0.30 cents on the dollar on that 30 th day then the pay out will be: $10 million * (1 - $0.30) = $7 million dollar payout

Profitability If the underlying goes into default, the protection buyer stops paying the seller that quarterly amount immediately, and receives payment in 30 days. This can create extremely profitable situations For example: A protection buyer purchases $10 million in protection on an entity with 300 basis points (fairly risky company) and a maturity of 5 years The underlying defaults in 12 months and the senior debt drops to $0.50 cents on the dollar ($ 10 million * (1 - $0.50)) – ($10 million * 3%) = $4.7 million

Criticism/Controversy

Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. -Matthew Philips, MSNBC-Newsweek

Criticism/Controversy Famous Cases in 2008: AIG - defaulted on $14 billion worth of credit default swaps made with various investment banks, insurance companies and other entities, and needed the American government to bail them out Bankruptcy of Lehman Brothers - due to subprime mortgage crisis Lehman Brothers declared bankruptcy, and caused nearly $400 billion to become payable to the buyers of CDS in Lehman Brothers

Criticism/Controversy Original intent: to spread risk and act as insurance on loan exposure Unintended side affects: Created more risk, with very little leverage and no regulation Created more negative speculation Became more of a money making scheme than a device to protect and hedge

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