Credit default swap

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A credit default swap (CDS) is a credit derivative contract between two counterparties,
whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or
"floating rate payer" in exchange for the right to a payoff if there is a default[1] or "credit
event" in respect of a third party or "reference entity".

If a credit event occurs, the typical contract either settles by delivery by the buyer to the
seller of a (usually defaulted) debt obligation of the reference entity against a payment by
the seller of the par value ("physical settlement") or the seller pays the buyer the
difference between the par value and the market price of a specified debt obligation,
typically determined in an auction ("cash settlement").

A credit default swap resembles an insurance policy, as it can be used by a debt holder to
hedge, or insure against a default under the debt instrument. However, because there is no
requirement to actually hold any asset or suffer a loss, a credit default swap can also be
used for speculative purposes and is not generally considered insurance for regulatory
purposes.

Contents
[hide]
 1 Market
 2 Structure and features
o 2.1 Terms of a typical CDS contract
o 2.2 Quotes of a CDS contract
 3 Pricing and valuation
o 3.1 Probability model
o 3.2 No-arbitrage model
 4 Uses
o 4.1 Hedging
o 4.2 Speculation
 5 Taxation
 6 Criticisms
 7 Operational issues in settlement
 8 LCDS
 9 See also
 10 References
 11 External links

o 11.1 In the news

 [edit] Market
Credit default swaps are the most widely traded credit derivative product[2] and the Bank
for International Settlements reported the notional amount on outstanding OTC credit
default swaps to be $42.6 trillion[1] in June 2007, up from $28.9 trillion in December
2006 ($13.9 trillion in December 2005) and by the end of 2007 there were an estimated
USD 45 trillion worth of Credit Default Swap contracts.[3]

In the US, the Office of the Comptroller of the Currency reported the notional amount on
outstanding credit derivatives from 882 reporting banks to be $5.472 trillion at the end of
March, 2006.

[edit] Structure and features

[edit] Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the 2003

Credit Derivatives Definitions as published by the International Swaps and Derivatives
Association. The confirmation typically specifies a reference entity, a corporation or
sovereign that generally, although not always, has debt outstanding, and a reference
obligation, usually an unsubordinated corporate bond or government bond. The period
over which default protection extends is defined by the contract effective date and
scheduled termination date.

The confirmation also specifies a calculation agent who is responsible for making
determinations as to successors and substitute reference obligations, and for performing
various calculation and administrative functions in connection with the transaction. By
market convention, in contracts between CDS dealers and end-users, the dealer is
generally the calculation agent, and in contracts between CDS dealers, the protection
seller is generally the calculation agent. It is not the responsibility of the calculation agent
to determine whether or not a credit event has occurred but rather a matter of fact that,
pursuant to the terms of typical contracts, must be supported by publicly available
information delivered along with a credit event notice. Typical CDS contracts do not
provide an internal mechanism for challenging the occurrence or non-occurrence of a
credit event and rather leave the matter to the courts if necessary, though actual instances
of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment
obligations by the protection seller and delivery obligations by the protection buyer.
Typical credit events include bankruptcy with respect to the reference entity and failure
to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North
American investment grade corporate reference entities, European corporate reference
entities and sovereigns generally also include restructuring as a credit event, whereas
trades referencing North American high yield corporate reference entities typically do
not. The definition of restructuring is quite technical but is essentially intended to respond
to circumstances where a reference entity, as a result of the deterioration of its credit,
negotiates changes in the terms in its debt with its creditors as an alternative to formal
insolvency proceedings (i.e., it restructures the debt). This practice is far more typical in
jurisdictions that do not provide protective status to insolvent debtors similar to that
provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns
arising out of Conseco's restructuring in 2000 led to the credit event's removal from
North American high yield trades.[2]

Finally, standard CDS contracts specify deliverable obligation characteristics that limit
the range of obligations that a protection buyer may deliver upon a credit event. Trading
conventions for deliverable obligation characteristics vary for different markets and CDS
contract types. Typical limitations include that deliverable debt be a bond or loan, that it
have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to
transfer restrictions (other than Rule 144A), that it be of a standard currency and that it
not be subject to some contingency before becoming due.

[edit] Quotes of a CDS contract

Sellers of CDS contracts will give a par quote (see par value) for a given reference entity,
seniority, maturity and restructuring e.g. a seller of CDS contracts may quote the
premium on a 5 year CDS contract on Ford Motor Company senior debt with modified
restructuring as 100 basis points. The par premium is calculated so that the contract has
zero present value on the effective date. This is because the expected value of protection
payments is exactly equal and opposite to the expected value of the fee payments. The
most important factor affecting the cost of protection provided by a CDS is the credit
quality (often proxied by the credit rating) of the reference obligation. Lower credit
ratings imply a greater risk that the reference entity will default on its payments and
therefore the cost of protection will be higher.

The swap adjusted spread of a CDS should trade closely with that of the underlying cash
bond issued by the reference entity. Misalignments in spreads may occur due to technical
minutiae such as specific settlement differences, shortages in a particular underlying
instrument, and the existence of buyers constrained from buying exotic derivatives. The
difference between CDS spreads and Z-spreads or asset swap spreads is called the basis.

To give an example, ABC Corporation may have its credit default swaps currently
trading at 265 basis points. In other words, the cost to insure 10 million euros of its debt
would be 265,000 euros per annum. If the same CDS had been trading at 170 basis points
a year before, it would indicate that markets now view ABC as facing a greater risk of
default on its obligations.

[edit] Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default
swaps. The first, which for convenience we will refer to as the 'probability model', takes
the present value of a series of cashflows weighted by their probability of non-default.
This method suggests that credit default swaps should trade at a considerably lower
spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by Hull and White, uses a no-
arbitrage approach.

[edit] Probability model

Under the probability model, a credit default swap is priced using a model that takes four
inputs:

 the issue premium,

 the recovery rate,
 the credit curve for the reference entity and
 the LIBOR curve.

If default events never occurred the price of a CDS would simply be the sum of the
discounted premium payments. So CDS pricing models have to take into account the
possibility of a default occurring some time between the effective date and maturity date
of the CDS contract. For the purpose of explanation we can imagine the case of a one
year CDS with effective date t0 with four quarterly premium payments occurring at times
t1, t2, t3, and t4. If the nominal for the CDS is N and the issue premium is c then the size of
the quarterly premium payments is Nc / 4. If we assume for simplicity that defaults can
only occur on one of the payment dates then there are five ways the contract could end:
either it does not have any default at all, so the four premium payments are made
and the contract survives until the maturity date, or a default occurs on the first,
second, third or fourth payment date. To price the CDS we now need to assign
probabilities to the five possible outcomes, then calculate the present value of the
payoff for each outcome. The present value of the CDS is then simply the present value
of the five payoffs multiplied by their probability of occurring.

This is illustrated in the following tree diagram where at each payment date either the
contract has a default event, in which case it ends with a payment of N(1 − R) shown in
red, where R is the recovery rate, or it survives without a default being triggered, in
which case a premium payment of Nc / 4 is made, shown in blue. At either side of the
diagram are the cashflows up to that point in time with premium payments in blue and
default payments in red. If the contract is terminated the square is shown with solid
shading.
The probability of surviving over the interval ti − 1 to ti without a default payment is pi and
the probability of a default being triggered is 1 − pi. The calculation of present value,
given discount factors of δ1 to δ4 is then

Default Payment
Description Premium Payment PV Probability
PV

Default at
time t1

Default at
time t2

Default at
time t3
Default at
time t4

No defaults

The probabilities p1, p2, p3, p4 can be calculated using the credit spread curve. The
probability of no default occurring over a time period from t to t + Δt decays
exponentially with a time-constant determined by the credit spread, or mathematically p
= exp( − s(t)Δt) where s(t) is the credit spread zero curve at time t. The riskier the
reference entity the greater the spread and the more rapidly the survival probability
decays with time.

To get the total present value of the credit default swap we multiply the probability of
each outcome by its present value to give

[edit] No-arbitrage model

In the 'no-arbitrage' model proposed by both Duffie, and Hull and White, it is assumed
that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas
Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying
assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of
the swap on default), which may invalidate the no-arbitrage assumption. However the
Duffie approach is frequently used by the market to determine theoretical prices. Under
the Duffie construct, the price of a credit default swap can also be derived by
calculating the asset swap spread of a bond. If a bond has a spread of 100, and the
swap spread is 70 basis points, then a CDS contract should trade at 30. However
owing to inefficiencies in markets, this is not always the case. The difference between
the theoretical model and the actual price of a credit default swap is known as the basis.
[citation needed]
[edit] Uses
Like most financial derivatives, credit default swaps can be used to hedge existing
exposures to credit risk, or to speculate on changes in credit spreads.

[edit] Hedging

Credit default swaps can be used to manage credit risk without necessitating the sale of
the underlying cash bond. Owners of a corporate bond can protect themselves from
default risk by purchasing a credit default swap on that reference entity.

For example, a pension fund owns $10 million worth of a five-year bond issued by Risky
Corporation. In order to manage the risk of losing money if Risky Corporation defaults
on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of
$10 million that trades at 200 basis points. In return for this credit protection, the pension
fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative
Bank. If Risky Corporation does not default on its bond payments, the pension fund
makes quarterly payments to Derivative Bank for 5 years and receives its $10 million
loan back after 5 years from the Risky Corporation. Though the protection payments
reduce investment returns for the pension fund, its risk of loss in a default scenario is
eliminated. If Risky Corporation defaults on its debt 3 years into the CDS contract, the
pension fund would stop paying the quarterly premium, and Derivative Bank would
ensure that the pension fund is refunded for its loss of $10 million (either by taking
physical delivery of the defaulted bond for $10 million or by cash settling the difference
between par and recovery value of the bond). Another scenario would be if Risky
Corporation's credit profile improved dramatically or it is acquired by a stronger
company after 3 years, the pension fund could effectively cancel or reduce its original
CDS position by selling the remaining two years of credit protection in the market.

[edit] Speculation

Credit default swaps give a speculator a way to make a large profit from changes in a
company's credit quality. A protection seller in a credit default swap effectively has an
unfunded exposure to the underlying cash bond or reference entity, with a value equal to
the notional amount of the CDS contract.

For example, if a company has been having problems, it may be possible to buy the
company's outstanding debt (usually bonds) at a discounted price. If the company has $1
million worth of bonds outstanding, it might be possible to buy the debt for $900,000
from another party if that party is concerned that the company will not repay its debt. If
the company does in fact repay the debt, you would receive the entire $1 million and
make a profit of $100,000. Alternatively, one could enter into a credit default swap with
the other investor, by selling credit protection and receiving a premium of $100,000. If
the company does not default, one would make a profit of $100,000 without having
invested anything.
It is also possible to buy and sell credit default swaps that are outstanding. Like the bonds
themselves, the cost to purchase the swap from another party may fluctuate as the
perceived credit quality of the underlying company changes. Swap prices typically
decline when creditworthiness improves, and rise when it worsens. But these pricing
differences are amplified compared to bonds. Therefore someone who believes that a
company's credit quality would change could potentially profit much more from investing
in swaps than in the underlying bonds, although encountering a greater loss potential.

[edit] Taxation
The U.S. federal income tax treatment of credit default swaps is uncertain.[4]
Commentators generally believe that, depending on how they are drafted, they are either
notional principal contracts or options for tax purposes,[5] but this is not certain. There is a
risk of having credit default swaps recharacterized as different types of financial
instruments because they resemble put options and credit guarantees. In particular, the
degree of risk depends on the type of settlement (physical/cash and binary/FMV) and
trigger (default only/any credit event).[6] If a credit default swap is a notional principal
contract, periodic and nonperiodic payments on the swap are deductible and included in
ordinary income.[7] If a payment is a termination payment, its tax treatment is even more
uncertain.[8] In 2004, the Internal Revenue Service announced that it was studying the
characterization of credit default swaps in response to taxpayer confusion,[9] but it has not
yet issued any guidance on their characterization. A taxpayer must include income from
credit default swaps in ordinary income if the swaps are connected with trade or business
in the United States.[10]

[edit] Criticisms
Warren Buffett famously described derivatives bought speculatively as "financial
weapons of mass destruction." In Berkshire Hathaway's annual report to shareholders in
2002, he said, "Unless derivatives contracts are collateralized or guaranteed, their
ultimate value also depends on the creditworthiness of the counterparties to them. In the
meantime, though, before a contract is settled, the counterparties record profits and losses
-often huge in amount- in their current earnings statements without so much as a penny
changing hands. The range of derivatives contracts is limited only by the imagination of
man (or sometimes, so it seems, madmen)." The same report, however, also states that he
uses derivatives to hedge, and that some of Berkshire Hathaway's subsidiaries have sold
and currently sell derivatives with notional amounts in the tens of billions of dollars.[citation
needed]

The market for credit derivatives is now so large, in many instances the amount of credit
derivatives outstanding for an individual name are vastly greater than the bonds
outstanding. For instance, company X may have $1 billion of outstanding debt and $10
billion of CDS contracts outstanding. If such a company were to default, and recovery is
40 cents on the dollar, then the loss to investors holding the bonds would be $600 million.
However the loss to credit default swap sellers would be $6 billion. When the CDS have
been made for purely speculative purposes, in addition to spreading risk, credit
derivatives can also amplify those risks. If the CDS were being used to hedge, the
notional value of such contracts would be expected to be less than the size of the
outstanding debt as the majority of such debt will be owned by investors who are happy
to absorb the credit risk in return for the additional spread or risk premium. A bond
hedged with CDS will, at least theoretically, generate returns close to LIBOR but with
additional volatility. Long term investors would consider such returns to be of limited
value. However speculators may profit from these differences and therefore improve
market efficiency by driving the price of bonds and CDS closer together.

However CDS premiums can act as a good barometer of company's health. If investors
are not sure about a firm's credit quality they will demand protection thus pushing up
CDS spreads on that name in the market. Equity markets will then draw a cue from the
credit markets and push down the stock price based on fear of corporate default. For
example the credit spread of Bear Stearns widened significantly in the period
immediately prior to being bailed out by the Fed and JP Morgan providing equity
investors with advance warning of impending problems at the company.

[edit] Operational issues in settlement

In the US, the settlement and processing of a CDS contract is currently the subject of
concern by the US Federal Reserve. In 2005, the Federal Reserve obtained a commitment
by 14 major dealers to upgrade their systems and reduce the backlog of "unprocessed"
CDS contracts. As of January 31, 2006, the dealers had met their commitment and
achieved a 54% reduction.[3]

In addition, growing concern over the sheer volume of CDS contracts potentially
requiring physical settlement after credit events for names actively traded in the single-
name and index-trade market where the notional value of CDS contracts dramatically
exceeds the notional value of deliverable bonds has led to the increasing application of
cash settlement auction protocols coordinated by ISDA. Successful auction protocols
have been applied following credit events in respect of Collins & Aikman, Delphi
Corporation, Delta Air Lines and Northwest Airlines, Calpine Corporation, Dana
Corporation, Dura Operating Corporation and Quebecor. ISDA is also using a protocol
for the settlement of contracts on Fannie Mae and Freddie Mac debt, after these entitities
were placed in conservatorship.[4]

[edit] LCDS
A new type of default swap is the "loan only" credit default swap (LCDS). This is
conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying
protection is sold on syndicated secured loans of the Reference Entity rather than the
broader category of "Bond or Loan". Also, as of May 22, 2007, for the most widely
traded LCDS form, which governs North American single name and index trades, the
default settlement method for LCDS shifted to auction settlement rather than physical
settlement. The auction method is essentially the same that has been used in the various
ISDA cash settlement auction protocols, but does not require parties to take any
additional steps following a credit event (i.e., adherence to a protocol) to elect cash
settlement. On October 23, 2007, the first ever LCDS auction was held for Movie
Gallery.[5]

Because LCDS trades are linked to secured obligations with much higher recovery values
than the unsecured bond obligations that are typically assumed to be cheapest to deliver
in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on
the same name.

[edit] See also

 Credit derivative
 Credit default swap index
 Credit default option
 Swap (finance)
 Recovery Swap

[edit] References
1. ^ CFA Institute. (2008). Derivatives and Alternative Investments. pg G-11. Boston:
Pearson Custom Publishing. ISBN 0-536-34228-8.
2. ^ "British Bankers Association Credit Derivatives Report".
3. ^ Morgensen, Gretchen (2008-02-17). "Arcane Market Is Next to Face Big Credit Test",
The New York Times. Retrieved on 2008-02-17.
4. ^ Nirenberg, David Z. & Steven L. Kopp. “Credit Derivatives: Tax Treatment of Total
Return Swaps, Default Swaps, and Credit-Linked Notes,” Journal of Taxation, Aug.
1997: 1. Peaslee, James M. & David Z. Nirenberg. FEDERAL INCOME TAXATION OF
SECURITIZATION TRANSACTIONS: Cumulative Supplement No. 7, November 26, 2007,
http://www.securitizationtax.com: 85. Retrieved July 28, 2008.
5. ^ Peaslee & Nirenberg, 129.
6. ^ Nirenberg & Kopp, 8.
7. ^ Id.
8. ^ Id.
9. ^ Peaslee & Nirenberg, 89.
10. ^ Department of the Treasury, Internal Revenue Service, at the IRS website. “2007
Instructions for Form 1042-S: Foreign Person’s U.S. Source Income Subject to
Withholding,” http://www.irs.gov/pub/irs-pdf/i1042s_07.pdf: 4. Retrieved July 28, 2008.

John Dizard: An appetite for making free money

By John Dizard
Published: October 23 2006 22:25 | Last updated: October 23 2006 22:25
 Free money. Profit – generated on billions of dollars of capital – without risk. Too good to be
true, right? Tell that to the people putting on “negative basis trades”.

Over the past few months professional managers of US dollar bond portfolios have been buying
corporate bonds, then buying the credit default swaps (CDSs) that allow them to cover the default
risk on the bonds. That should not be profitable, but it is. Usually, the cost of complete CDS
protection will be greater than the coupon on the bonds; the difference is called the “basis”.

Now, though, thanks to a bizarre anomaly in the financial markets, the cost of protection using the
CDS market is less than the interest yield on the bonds. So we have “negative basis”. You are
being paid for taking the risk of owning corporate credit, but you do not have to take the risk.

How much are you being paid? That depends on the bond. Of the 150 most frequently traded
corporate names in the US bond world, about a third have negative basis spreads available that
are more than 10 basis points. There are five or 10 names with more than 30bp. That may not
sound like a lot, but on billions of dollars it adds up. The bond manager can, without difficulty, buy
10 bond positions of $10m each, buy the corresponding CDS protection and collect $100,000 a
year of risk-free money.

For a short morning’s work, the trader’s cut of the profits should buy them two weeks or a month’s
rent on a summer house in the Hamptons, depending on whether they want to be on the north
side (less fashionable) or the south side (more fashionable, close to the beach) of Highway 27.
And again, the credit and interest rate risk have been hedged away.

So the more thoughtful are picking up this trade and shaking it to see what parts come out, if, for
example, credit spreads widen dramatically in a more nervous environment. Mike Mutti, co-head
of corporate credit strategy and managing director of Bear Stearns, says: “Such a position, that is,
buying bonds and buying CDS, would likely perform well, since CDS typically widens much more
than bonds when spreads widen.”

There were two forces that created the negative basis trade opportunities. One was the demand
for “synthetic” collateralised debt obligations (CDOs), comprising portfolios of CDS contracts that
could be sliced into convenient high- and low-risk components. The other was a favourable
interest rate swaps curve.

As Mr Mutti says: “Typically, negative basis trades are not very common. However, strong
demand for synthetic CDOs over the summer contributed to tighter CDS spreads, while bond
spreads underperformed due to higher financing and hedging costs. Consequently, when the bulk
of investors returned from the summer, they found numerous opportunities to buy bonds and buy
protection on the same name and have positive carry.”

To eliminate the interest rate risk on the bonds, managers have to have their cash flows swapped
into London interbank offered rate, which is done through the swaps market. David Goldman, the
fixed income strategist at Cantor Fitzgerald, says that “the interest rate swap curve has traded
within a very narrow range for the last two months. By far the biggest influence on the swaps
market is the yield curve and mortgage duration”. These have kept swap spreads tight, which
lowers the cost of the negative basis trades.

There are other pitfalls. As another credit manager says: “Look at News America bonds. They’re
trading at a negative basis of 30bp, which is wide. But the dollar price of the News America bonds
is 117. If the bonds were to default, the CDS you bought to hedge away their risk would only pay
you par for the bonds, so you would have 17 percentage points of potential loss against only
30bp of gain.”

Another driver of the negative basis trades is the prospect of leveraged buy-outs. In those, the
trader’s CDS protection will rise due to the higher leverage in the company. Because corporate
bonds often have restrictive covenants in them, the LBO sponsors will buy them back, frequently
at a premium to the previous market price.

This game is going on thanks to excess liquidity in the world, even after the central banks have
supposedly tightened their policies. Chris Whalen, of Institutional Risk Analytics, says: “It’s kind of
sad. People are running out of ways to deploy their capital intelligently, so they turn to this kind of
financial masturbation, trying to get their performance far enough inside the herd so they don’t
have to deal with redemptions.”

Fond as Wall Streeters are of comparing their work with battlefield heroics, people (such as me)
are always talking about deals or trades “blowing up”. Now there is a takeover deal that looks as
though it might blow up because a few real world things actually blew up.

At the end of August, Western Refining offered to pay $83 a share for Giant Industries, which
owns three refineries. The idea was to build a 216,000 barrels a day, geographically diversified
operation. It seemed like an aggressive deal, since Western was paying all cash, a premium of
more than 15 per cent to the market and absorbing $275m in debt. Also, this could be close to the
top of the refining margin cycle.

Then on October 1, the diesel unit of Giant’s refinery in Yorktown, Virginia, caught on fire and was
shut down. On October 6, Giant’s Ciniza refinery near Gallup, New Mexico, was hit by another
fire that shut down the refinery. This followed earlier fires at Giant refineries in 2004 and 2005.

The fires could raise questions about the adequacy of Giant’s maintenance practices, and repairs
will add to the high acquisition price.

When I contacted Scott Weaver, a major Western shareholder and the company’s investor
relations person, he said: “Giant is assessing the damage and the effects on operations. We are
waiting for the facts; when we have them we will assess the situation.”

If you have Giant stock, I would sell it.