FUNCTIONING OF CREDIT DEFAULT SWAPS

Credit Derivatives
Credit derivatives are financial instruments that derive their value from an underlying credit asset
or pool of credit assets, such as bonds or mortgages, and are designed to transfer and manage
credit risk. The underlying asset being protected is the reference asset, which is issued by the
reference entity. The payouts are a function of the credit worthiness of an issuer. In essence, they
offer credit holders or speculators a way to strip away certain components of the credit package,
namely credit risk. This allows investors to tailor the risk/reward profile of these assets to suit their
investment needs.

Credit Default Swaps

Introduction

A credit default swap (CDS) is a credit derivatives instrument that provides insurance against the
risk of a default by a particular company. It is a contract that gives the buyer of the contract a right
to receive compensation from the seller of the contract in the event of default of a third party. The
fundamental role of credit default swaps is to transfer credit risk between a party wishing to reduce
credit risk, often called the protection buyer, risk seller or risk hedger (the party going short the
credit), and the party wishing to acquire or hold credit risk, often called the protection seller or risk
buyer (the party going long the credit). The third party on which credit event protection is bought
and sold (who have issued debt) is referred to as the Reference Entity. Each CDS has a notional
amount and it requires the buyer to pay a premium called CDS spread. The credit event is binary in
nature, i.e. it occurs, or it doesn’t. Typical credit events include (a) a filing for bankruptcy by the
third party on whose bond the CDS was issued, (b) any failure by the third party to pay interest on
its bonds and (c) any restructuring of the debt.

Structure of Credit Default Swaps

Although it shares fundamental characteristics with other swaps, the credit default swap (CDS) is
quite different. A CDS is the exchange of two cash flows: a fee payment and a conditional payment
which occurs only if certain circumstances are met. More precisely, the CDS will have value for the
protection buyer only if these conditions are met, whereas the protection seller will receive the
predetermined fee in all scenarios.

A CDS is analogous to a specific type of insurance option in which default of an asset triggers
payment. One party buys the protection and insures itself against the risk of default or other credit
impairment on an underlying credit instrument, whereas the other party accepts this risk (of an
uncertain event) in exchange for a certain fee. The protection buyer holds a risky asset and pays a
reasonable fee (premium called CDS spread) to reduce the severity of possible adverse outcomes.
The protection seller values the premium’s cash flows against the risk of adverse outcomes and
possible payouts.
Cash Flows of a single-name CDS

Protection Protection Fee (CDS Spread)

Buyer/Owner of Protection
Underlying Asset Seller

Payment only if credit event on underlying

asset occurs (bankruptcy, failure to pay or
restructuring)

If default occurs, the CDS is activated and terminates with the payment according to the predetermined
conditions of the contract. The payment can be 100% of the face value or a percentage of the total
(nominal) CDS commitment, depending on the importance of the loss triggered by the credit event.
There are two payment modes:

 Physical settlement – the protection buyer remits the asset to the protection seller against full
face value payment

Bond (if a credit event occurs)

Protection Protection
Buyer/Owner of Buyer/Owner of
Underlying Asset Underlying Asset
Par amount (if a credit event occurs)

On August 15, 2018, two parties enter into a credit default swap. The terms of the contract are a five-year
CDS, with the protection buyer paying 120 basis points (bps) annually for protection on a $100 million
bond position (referenced asset). The contract’s payment schedule calls for semi‑annual payments, with
physical delivery of the bonds in the event of default. The protection buyer pays $600,000 every six
months to the seller beginning on February 15, 2019 [(120 bps × $100 million) ÷ 2] until the end of the
contract, or until the credit event (default) occurs. The buyer will receive a payout only if the reference
entity defaults (triggering the credit event). If this happens, the protection seller must buy the bonds for
$100 million.

 Cash settlement – the protection buyer retains the asset and receives the difference between
face value and recovery value, as established by an independent assessor

Protection Fee (Premium)

Protection Protection
Buyer/Owner of Buyer/Owner of
Underlying Asset Underlying Asset
Cr Credit Event Payment (if a credit event occurs)
If above example called for cash settlement rather than physical settlement, the recovery value would be
determined by an independent assessor using the recovery rate, which is the realisable rate of recovery
upon default. If the bonds’ recovery rate is $200 per $1000 of par value (20%) after the default, the cash
payout the protection seller must make is $80 million ($100 million– $20 million recovery value).

Thus, the CDS is a swap transaction under which:

 On start date, no payments are made by either party; and

 On periodic interim dates, protection buyer pays to protection seller pre-agreed amounts;
and
 If a Credit Event does not occur, no further payments are made at maturity; or
 If a Credit Event occurs and physical settlement applies, the transaction shall accelerate and
protection buyer shall deliver the Deliverable Obligations (For eg bond) to protection seller
against payment of a pre-agreed amount (For eg Par amount of a bond)
 If a Credit Event occurs and cash settlement applies, the transaction shall accelerate and
protection seller shall pay to protection buyer equal to [(Par-recovery value)*notional]

Credit Default Swaps in India:

Credit default swaps were introduced into India in 2011 as part of an overall strategy by the RBI to
further deepen and widen the corporate bond market as banks and other financial institutions use
CDSs to transfer and manage credit risk through these instruments.

As with other OTC derivatives in India, there are two types of participants in the CDS market:
market makers and users. Market makers are entities permitted to quote both buy and/or sell CDS
spreads. They are permitted to buy credit protection without having the underlying bond. Market
makers include commercial banks, primary dealers and non-bank financial companies. Insurance
and mutual fund companies are not currently market makers but can become such with the
approval of their respective regulators.

Users are entities permitted to buy CDSs only to hedge the underlying credit risk of holding
corporate bonds. Examples of users include listed corporations, insurance companies and mutual
funds.

The salient features of CDSs in India include that they only be allowed on all listed corporate bonds,
rated unlisted corporate bond, cannot be written on securities that have an original maturing of less
than one year, be denominated in Rupees, that only plain-vanilla bonds be allowed and that all CDS
trades have an RBI regulated entity on at least one side of the trade.
The above picture represents 5Yr Sovereign Credit Default Spreads which are the most liquid credit
default spreads.

A CDS spread of 23.30 bps for the US means it would cost about $23,300 to buy protection on
$10,000,000 in US government debt with an implied probability of default of 0.39%.Similarly, a CDS
spread of 227.42 bps for the India means it would cost about $227,420 to buy protection on
$10,000,000 in Indian government debt with an implied probability of default of 3.79%.

For basic understanding, ignore data Var 1m and Var 6m.