7/16/22, 4:20 PM A Beginner’s Guide to Credit Default Swaps (Part 2) – Rich Newman

Rich Newman

A Beginner’s Guide to Credit Default Swaps (Part 2)


beginners guide, bonds, cds, credit default swap, derivatives, introduction, tutorial 
July 19,
2011April 19, 2018 4 Minutes
Introduction

Part 1 of the ‘Beginner’s Guide to Credit Default Swaps’

(https://richnewman.wordpress.com/2007/12/09/a-beginners-guide-to-credit-default-swaps/) was written
in 2007. Since that time we have seen what many are calling the greatest financial crisis since the Great
Depression, and a global recession.

Rightly or wrongly, some of the blame for the crisis has been attributed to credit derivatives
(http://www.thestreet.com/story/10443559/credit-default-swaps-bad-enough-to-ban.html) and
speculation in them.  This has led to calls for a more transparent and better regulated credit default swap
(CDS) market. Furthermore the CDS market has grown very quickly, and by 2009 it had become clear
that some simple changes to operational procedures would benefit everyone.

As a result many changes in the market have already been implemented, and more are on the way. This
article will discuss these changes.  It will focus primarily on how the mechanics of trading a credit
default swap have changed, rather than the history of how we got here or why these changes have been
made. I’ll also briefly discuss the further changes that are on the way.

Overview of the Changes

The first thing to note is that nothing has fundamentally changed from the description of a credit default
swap in part 1 (https://richnewman.wordpress.com/2007/12/09/a-beginners-guide-to-credit-default-
swaps/). A credit default swap is still a contract that provides a kind of insurance against a company
defaulting on its bonds. If you have read and understood part one then you should understand how a
credit default swap works.

The main change that has happened is that credit default swap contracts have been standardized. This
standardization falls into three broad categories:

1. Changes to the premium, premium and maturity dates, and premium payments that simplify the
mechanics of CDS trading.
2. Changes to the processes around identifying whether a credit event has occurred.
3. Changes to the processes around what happens when a credit event has occurred.

Items 2 and 3 are extremely important, and have removed many of the problems that were discussed in
part 1 relating to credit events. However, they don’t affect the way credit default swaps are traded as
fundamentally as item 1, and are arguably more boring, so we’ll start with item 1.

The Non-Standard Nature of Credit Default Swaps Previously

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If I buy 100 IBM shares and then buy 100 more I know that I have a position of 200 IBM shares.  I can go
to a broker and sell 200 IBM shares to get rid of (close out) this position.

One of the problems with credit default swaps (CDS) as described in part 1 of this series of articles is that
you couldn’t do this.  Every CDS trade was different, and it was consequently difficult to close out
positions.

Using the description in part 1, consider the case where I have some senior IBM bonds.  I have bought
protection against IBM default using a five year CDS.  Now I decide to sell the bonds and want to close
out my CDS.  It’s difficult to do this by selling a five year CDS as described previously.  Even if I can get
the bonds being covered, the definition of default, the maturity date and all the premium payment dates
to match exactly it’s likely that the premiums to be paid will be different from those on the original
CDS.  This means a calculation has to be done for both trades separately at each premium payment date.

Standardization

To address this issue a standard contract has been introduced that has:

1.  Standard Maturity Dates

There are four dates per year, the ‘IMM dates’ (http://en.wikipedia.org/wiki/IMM_dates) that can be the
maturity date of a standard contract: 20th March, 20th June, 20th September, and 20th December.  This
means that if today is 5th July 2011 and I want to trade a standard five-year CDS I will normally enter
into a contract that ends 20th September 2016.  It won’t be a standard CDS if I insist my maturity date
has to be 5th July 2016.

2.  Standard Premium Payment Dates

The same four dates per year are the dates on which premiums are paid (and none other).  As a result
three months of premium are paid at every premium payment date.

Note that the use of IMM dates for CDS maturity and premium payment dates was already common
when I wrote part 1 of the article.

3.  Standard Premiums

In North America, standard contracts ONLY have premiums of 100 or 500 basis points per annum (1% or
5%).  In Europe, Asia and elsewhere a wider range of premiums is traded on standard contracts,
although this is still restricted.  How this works in practice will be explained in part 3.

4.  Payment of Full First Coupon

Standard contracts pay a ‘full first coupon’.  What this means is that if I buy a CDS midway between the
standard premium payment dates I still have to pay a full three months’ worth of premium at the next
premium date.  Note that ‘coupon’ here means ‘premium payment’.

For example, if I enter into a CDS with face value $100m on 5th July 2011 with a premium of 5% I will
have to pay 3 months x 5% x 100m on the 20th September.  This is in spite of the fact that I have not been
protected against default for the full three months.

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Note that for the standard premiums and the payment of full first coupon to work we now have upfront
fees for CDS.  Again this will be explained in more detail in part 3
(https://richnewman.wordpress.com/2011/08/04/a-beginner%e2%80%99s-guide-to-credit-default-swaps-
part-3/).

Impact of these Changes

What all this means is that we have fewer contract variations in the market.  The last item in particular
means that a position in any given contract always pays the same amount at every premium date: we
don’t need to make any adjustments for when the contract was traded.

In fact, in terms of the amount paid EVERY contract with the same premium (e.g. 500 bps) pays the same
percentage of face value at a premium date, regardless of reference entity.  This clearly simplifies coupon
processing.  It also allows us to more easily net positions in credit default swaps in our systems.

Conclusion

One of the major changes in the CDS market since part 1

(https://richnewman.wordpress.com/2007/12/09/a-beginners-guide-to-credit-default-swaps/) was written
is that contracts have been largely standardized.  More detail on this and other changes will be given in
part 3 (https://richnewman.wordpress.com/2011/08/04/a-beginner%e2%80%99s-guide-to-credit-default-
swaps-part-3/).

Tagged:
beginners guide,
cds,
credit default swap,
introduction,
tutorial

Published by richnewman

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10 thoughts on “A Beginner’s Guide to Credit Default

Swaps (Part 2)”

Sumi says:
July 20, 2011 at 7:07 am
Excellent work and thanks for the same. If possible give details about FRN and Total Return Swaps

 Reply
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7/16/22, 4:20 p
PMy A Beginner’s Guide to Credit Default Swaps (Part 2) – Rich Newman

Anonymous says:
December 17, 2011 at 11:14 pm
i find this area so complicated. you have made it really simple to understand. Thank you so very
much

Claire from London

 Reply
Pingback: A Beginner’s Guide to Credit Default Swaps (Part 1) « Rich Newman
anonemiss says:
March 9, 2012 at 10:03 pm
Where can I find a copy of the “standard contract”?

 Reply
hochiminhfreetours says:
September 13, 2012 at 4:54 pm
I am a student researching for the CDS. Your works help me a lot. Please tell me where can I find a
copy of the “standard contract”? Thank you so much.

 Reply
Pingback: A Beginner’s Guide to Credit Default Swaps (Part 1) « xu1892
Pingback: A Beginner’s Guide to Credit Default Swaps (Part 3) « xu1892
gc says:
July 16, 2015 at 6:45 am
fantastic. never read in detail so much on any other site. simply amazing. you are best.

 Reply
Gautam Chatterjee says:
January 20, 2017 at 9:53 am
What is not clear is that if you buy a CDS, then how is that your shorting the market as depicted in
the” big short” ?

 Reply
Anonymous says:
December 19, 2017 at 3:42 pm
Very useful

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