Credit Default Swap
What is a CDS?
• A credit default swap (CDS) a swap contract
in which the buyer of the CDS makes a series
of payments to the seller and, in exchange,
receives a payoff if a credit instrument
(typically a bond or loan) goes into default or on
the occurrence of a specified credit event (for
example bankruptcy or restructuring).
• Credit Default Swaps can be bought by any
(relatively sophisticated) investor; it is not
necessary for the buyer to own the underlying
credit instrument. This is the major difference
between CDS and insurance.
• Failure to Pay
• Repudiation: Deny a contract
• Moratorium: Delay payment
The payoff of a CDS
• If a credit event occurs, the protection
Protection buyer payoff =
Bond par value – Bond market value
Figure 12.3 Depiction of the cash flows in a credit
default swap. The investor owns the reference asset,
which was issued by XYZ. The investor buys a credit
default swap and pays 40 basis points per year in
exchange for the swap writer’s payment in the event of
a default by XYZ.
• Credit Default Swaps were invented in 1997 by a
team working for JPMorgan Chase.
• Credit Default Swaps became legal, and illegal to
regulate, with the Commodity Futures
Modernization Act of 2000.
• They were introduced and rushed through
congress as a companion bill, the last day before
the Christmas holiday.
• It was never debated in the House or the Senate.
• The bill was 11,000 pages long.
• Less than a week after it was passed by congress,
President Clinton signed it into Public Law (106-
554) on December 21, 2000.
• As the market matured CDSs were
increasingly used by investors wishing to
bet for or against the likelihood that
particular companies or portfolios would
suffer financial difficulties; rather than
to insure against bad debt.
• The market size for Credit Default Swaps
began to grow rapidly from 2003, by late
2007 it was approximately ten times as
large as it had been four years previously.
Market as of 2008
• Credit default swaps are by far the most widely
traded credit derivative product.
• The Bank for International Settlements reported
the notional amount on outstanding credit default
swaps to be
– $42.6 trillion in June 2007, up from
– $28.9 trillion in December 2006,
– $13.9 trillion in December 2005.
• By the end of 2007 there were an estimated $45
trillion to $62.2 trillion worth of credit default
swap contracts outstanding worldwide.
Figure 1. Composition of the United States 15.5 trillion US
dollar CDS market at the end of 2008 Q2. Green tints show
Prime asset CDSs, reddish tints show sub-prime asset CDSs.
Numbers followed by "Y" indicate years until maturity.
Figure 2. Proportion of CDSs nominals (lower left) held by
United States banks compared to all derivatives, in 2008Q2.
The black disc represents the 2008 public debt.
Small net cash flows
• It is important to note that since default
is a relatively rare occurrence (historically
around 0.2% of investment grade
companies will default in any one year), in
most CDS contracts the only payments are
the spread payments from buyer to seller.
• Thus, although the above figures for
outstanding notional sound very large, the
net cash flows will generally only be a small
fraction of this total.
The trading of CDS
• There is no centralized exchange or clearing
house for CDS transactions; they are all done
over the counter (OTC). This has led to recent
calls for the market to open up in terms of
transparency and regulation.
• In November 2008, the Depository Trust and
Clearing Corp, which runs a warehouse for CDS
trade confirmations accounting for around 90% of
the total market, announced that it will release
market data on the outsanding notional of CDS
trades on a weekly basis.
• The data can be accessed on the DTCC's website.
• This announcement coincides with plans to
establish a centralized clearing house for CDS
transactions by the end of 2008.
• US regulators (such as the SEC and CFTC) are
• Currently two rival groups have announced their
– one group is made up of a consortium of banks along with
DTCC, the ICE and The Clearing Corporation,
– while the other is a joint venture between the Chicago
Mercantile Exchange and the hedge fund Citadel.
The Importance of a
• A clearing house would become the central
counterparty to both sides of a CDS
transaction, thereby reducing the
counterparty risk that both buyer and
• There are also ongoing discussions in
Europe as to whether a separate
European-regulated clearing house should
be established as well.