Credit Default Swaps (Part 1)

Credit default swaps are a financial instrument used to transfer and mitigate the risk of credit exposure. They are a bilateral contract between the buyer, who purchases protection of the credit risk, and the seller, who provides protection.

A credit default swap (CDS) is a contract between two parties where a protection buyer pays a premium to the protection seller in exchange for a payment if a credit event occurs to a reference entity. CDS are customizable, over-the-counter products and can be written to trigger in the event of bankruptcy, default, failure to pay, restructuring, or any other credit event of the reference entity. "Credit event" will usually determine whether the protection buyer has reason to demand payment from the protection seller. "Reference entity," which is the entity whose obligation is the subject of the swap.

Credit default swaps are a type of credit derivative that can be used to function as a sort of insurance or hedge against an existing investment. Credit default swaps are the largest type of credit derivative in terms of trading volume.

The CDS market has grown $180 billion in 1997; By 2004 it has grown to $5 trillion; In the 2006, $17 trillion; In 2010, it has an annual business of $70 trillion (notional amount).

As the CDS market increased in importance, tradable CDS indexes arose to allow players to trade a broader spectrum of credits at a lower cost and in a more liquid market (i.e. Dow Jones CDX and International Index Company Itraxx). The composition of each index is determined by member banks and a particular name remains in the index until the CDS is triggered due to a credit event. A new index is formed periodically but each incarnation of the index shares the majority of its names with the previous index. The member banks that help compose and price the index include sixteen major international banks. Each of the member banks makes a market in the CDS index and it is freely tradable with low bid-ask spreads of ½ to ¼ of a basis point. It pays the seller a premium relative to the amount of the debt obligation being covered—typically calculated by multiplying the principal amount by a number of basis points—called the spread—whose value is determined by the credit-worthiness of the third party.

Unlike hedging with less risky bonds which requires a cash outlay upfront, CDS do not subject the buyer to interest rate risk or funding risk. CDS allow hedgers or speculators to take an unfunded position solely on credit risk. The market originally started as an inter-bank market to exchange credit risk without selling the underlying loans but now involves financial institutions from insurance companies to hedge funds.

The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts.