Understanding Investing

Credit Default Swaps

Originally formed to provide banks with the means to transfer credit exposure, CDS has
grown as an active portfolio management tool. The performance of CDS, like that of
corporate bonds, is closely related to changes in credit spreads. This makes them an
effective tool for hedging risk, and efficiently taking credit exposure.

WHAT IS A CREDIT DEFAULT SWAP?

A COMMON CREDIT DEFAULT SWAP
A CDS is the most highly utilized type of credit derivative. In
TRANSACTION
its most basic terms, a CDS is similar to an insurance contract,
providing the buyer with protection against specific risks. Most
often, investors buy credit default swaps for protection against PROTECTION SELLER
a default, but these flexible instruments can be used in many
• Does not usually own underlying credit asset
ways to customize exposure to the credit market.
• Selling credit protection
CDS contracts can mitigate risks in bond investing by • Long credit exposure
transferring a given risk from one party to another without
transferring the underlying bond or other credit asset. Prior to
credit default swaps, there was no vehicle to transfer the risk of Credit default
a default or other credit event, from one investor to another. swap premium
paid periodically
In a CDS, one party “sells” risk and the counterparty “buys”
that risk. The “seller” of credit risk – who also tends to own the Payment only if
credit event occurs
underlying credit asset – pays a periodic fee to the risk “buyer.”
In return, the risk “buyer” agrees to pay the “seller” a set
amount if there is a default (technically, a credit event). CDS are
designed to cover many risks, including: defaults, bankruptcies
and credit rating downgrades. (For a more detailed list of CDS PROTECTION BUYER
credit events see the Commonly Established CDS Credit Events
table below). • Tends to own underlying credit asset
• Purchasing credit protection
The graphic below illustrates the credit default swap • Short credit exposure
transaction between the risk “seller,” who is also the protection
“buyer,” and the risk “buyer,” who is also the protection “seller.” Source: Credit Derivatives and Synthetic Structures, John Wiley & Sons. 2001

WHAT ARE THE CHARACTERISTICS OF CREDIT
DEFAULT SWAPS?
The credit default swap market is generally divided into
three sectors:
1. S ingle-credit CDS referencing specific corporates, bank
credits and sovereigns.
2. M
 ulti-credit CDS, which can reference a custom portfolio
of credits agreed upon by the buyer and seller,
3. C
 DS index. The credits referenced in a CDS are known as
“reference entities.” CDS range in maturity from one to 10
years although the five-year CDS is the most frequently
traded.
Credit default swaps provide a measure of protection against
previously agreed upon credit events. Below are the most
common credit events that trigger a payment from the risk
“buyer” to the risk “seller” in a CDS.
Commonly Established CDS Credit Events
Bankruptcy The reference entity becomes insolvent or is
unable to pay its debts
Failure to Pay The reference entity fails to make interest or
principal repayments when due
Debt Restructuring The configuration of debt obligations is
changed in such a way that the credit holder is
unfavorably affected
Obligation The debt obligations of the issuer become due
Acceleration or before their originally scheduled maturity date
Obligation Default
Repudiation/ The issuer of the underlying bond (the
Moratorium reference entity) rejects their debt, effectively
refusing to pay interest and principal
Source: International Swaps and Derivatives Association
The settlement terms of a CDS are determined when the CDS
contract is written. The most common type of CDS involves
exchanging bonds for their par value, although the settlement
can also be in the form of a cash payment equal to the
difference between the bonds’ market value and par value.
HOW HAS THE CREDIT DEFAULT SWAPS
MARKET EVOLVED?
The CDS market was originally formed to provide banks
with the means to transfer credit exposure and free up
Credit Default Swaps
regulatory capital. Today, CDS have become the engine that
drives the credit derivatives market. The growth of the CDS
market is due largely to CDS’ flexibility as an active portfolio
management tool with the ability to customize exposure to
corporate credit. Today the CDS market represents more than
$10 trillion in gross notional exposure1.
In addition to hedging credit risk, the potential benefits of
CDS include:
• Requiring only a limited cash outlay (which is significantly
less than for cash bonds)
• Access to maturity exposures not available in the
cash market
• Access to credit risk with limited interest rate risk
• Investments in foreign credits without currency risk
• At times, more liquidity than investing in the underlying
cash bonds
The performance of credit default swaps, like that of
corporate bonds, is closely related to changes in credit
spreads. This sensitivity makes them an effective tool for
portfolio managers to hedge or gain exposure to credit.
Credit default swaps also allow for arbitrage opportunities.
GLOSSARY
Credit/Default risk: The risk of loss of principal or loss of a financial
reward stemming from a borrower’s failure to repay loan or otherwise meet a
contractual obligation.
Central Counterparty (CCP): A clearing house that interposes itself
between counterparties to contracts traded in one or more financial markets,
becoming the buyer to every seller and the seller to every buyer and thereby
ensuring the future performance of open contracts.
Counterparty risk: The risk to each party of a contract that the counterparty
will not live up to its contractual obligations.
Corporate bond: Debt instrument issued by a private corporation, as distinct
from one issued by a government or government agency.
Credit spread: The yield differential between a corporate bond and an
equivalent maturity sovereign bond. For example, if the 10-year Treasury note
is trading at a yield of 3% and 10-year corporate bond is trading at a yield of
4%, the credit spread if 1% or 100bps.
Derivative: A security which derives its value from movements in an
underlying security, such as stocks, bonds, commodities, currencies and
interest rates.
Interest rate risk: When interest rates rise, the market value of fixed income
securities (such as bonds) declines. Similarly, when interest rates decline, the
market value of fixed income securities increases.
1
As of 30 June 2016. Source: BIS
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rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing
in derivatives could lose more than the amount invested. Credit default swap (CDS) is an over-the-counter (OTC) London
agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used
Milan
credit derivative instrument.
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Investors should consult their investment professional prior to making an investment decision. New York

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