A Lk at Cedit Default Swapsad Thei Impact the Eupea Debt Cisis
By Bryan Noeth and Rajdeep Sengupta
redit deault swaps (CDS) are nancialderivative contracts that are conceptu-ally similar to insurance contracts. A CDSpurchaser (the insured) pays ees to theseller (the insurer) and is compensated onthe occurrence o a specied credit event.ypically, such a credit event is the deaultor bankruptcy o a corporate or sovereignborrower (also known as the
). Te dierence between traditionalinsurance and CDS is that CDS purchasersneed not have any nancial stake in the re-erence entity. Tereore, buying a CDS canbe analogous to an individual insuring hisneighbor’s car and getting paid i the neigh-bor is involved in a car accident. Just like inan insurance contract, the individual pays aperiodic premium to a CDS seller in returnor compensation should the credit event(accident) occur. Importantly, the individualis compensated even though he may have nonancial stake in his neighbor’s car.
The Origins of CDS
CDS were introduced in the mid-1990s asa means to hedge risk against a credit event.Initially, commercial banks used CDS tohedge the credit risk associated with largecorporate loans. Te attractiveness o a CDScontract emerges rom the act that these aremade over the counter and generally adhereto the International Swaps and DerivativesAssociation’s (ISDA) master agreement.
Asa result, they allow transacting parties toavoid regulatory requirements imposed by more-ormal insurance arrangements. Withthe evolution o this market, CDS contractswere written on a variety o sovereign,corporate and municipal bonds, as well ason more-complex nancial instruments,such as mortgage-backed securities andcollateralized debt obligations. Unlike withinsurance arrangements, sellers o CDS werenot subject to signicant regulation andwere not required to hold reserves againstCDS in case o deault. It is widely believedthat this exacerbated the recent nancialcrisis by allowing nancial rms to sellinsurance on various securities backed by residential mortgages and other assets.
How Do They Work?
ypically, the CDS requires that the pur-chaser pay a spread (ee) quoted in percent-age (basis points) o the amount insured.For example, the protection buyer o aCDS contract o an insured amount o $20 million and a premium o 100 basispoints pays a (quarterly) premium o $50,000 to the CDS seller.
Te premiumscontinue until the contract expires or thecredit event occurs. Higher premiums indi-cate a greater likelihood o the credit event.Settlement occurs in one o two ways:physical or cash. Physical settlementrequires that the buyer o the protectiondeliver the insured bond to the seller, whopays the buyer the ace value o the loan.Te occurrence o the credit event wouldgenerally imply that the asset is trading wellbelow par. Conversely, in a cash settlementagreement, the seller o the CDS simply paysthe dierence between the par value and themarket price o the obligation o the reer-ence entity.
Suppose that in our example,the recovery rate on the obligation o thereerence entity is 40 percent on the occur-rence o the credit event; then, the protec-tion seller makes a one-time cash paymento $12 million to the protection buyer asshown in the diagram at the top o thenext column.
CDS Spreadsand the European Debt Crisis
CDS spreads are an important metric o deault risk—a higher spread on the CDSimplies a greater risk o deault by the reer-ence entity. Tis eature can provide useulinormation as to how nancial marketsperceive the risk o deault on corporate andsovereign debt. o illustrate this phenom-enon, we study changes in the CDS spreadson the debt o European nations over thepast ew years. Figure 1 illustrates spreadson ve-year CDS in Europe since 2005. Eachseries is an equally weighted index o country groupings where data are available—dis-tressed countries in the eurozone (EuropeanUnion members that use the euro as theircurrency), other countries in the eurozone,Western European countries that do not usethe euro as currency and Eastern Europeancountries that do not use the euro as cur-rency.
Prior to the crisis, CDS spreads werelow or all o the reerence countries, showingthat investors placed low probabilities onthese countries deaulting on their debts.Te onset o the nancial crisis in 2008raised the CDS spreads or all o the sampledgroups o countries, especially or those inEastern Europe. At the time, it was believedthat Eastern European countries reliedheavily on oreign capital ows to roll overtheir debt obligations. Te Russian deaultin the late 1990s had made investors wary o the ability o these countries to service their
Protection BuyerProtection SellerReference EntitySpreadProtection(1-Recovery Rate)*Notional Value
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