Credit Default Swap (CDS)

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					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.
          Credit events
•   Bankruptcy
•   Failure to Pay
•   Restructuring
•   Repudiation: Deny a contract
•   Moratorium: Delay payment
•   Suicide
   The payoff of a CDS
• If a credit event occurs, the protection
  buyer receives

  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.
        Market Growth
• 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.
   Exchange-listed CDS?
• 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
  monitoring negotiations.
• 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
     clearing house
• A clearing house would become the central
  counterparty to both sides of a CDS
  transaction, thereby reducing the
  counterparty risk that both buyer and
  seller face.
• There are also ongoing discussions in
  Europe as to whether a separate
  European-regulated clearing house should
  be established as well.