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
(CDS)?

A credit default swap (CDS) is a financial derivative or contract that allows an

investor to “swap” or offset his or her credit risk with that of another investor. For
example, if a lender is worried that a borrower is going to default on a loan, the
lender could use a CDS to offset or swap that risk.
 EXAMPLE OF CREDIT DEFAULT SWAP

Example, suppose that Lloyds TSB has lent money to riskymortgage.co.uk in the form of a
£1,000 bond.
Lloyds TSB may then purchase a credit default swap from another company e.g. a Hedge Fund.
If the firm (Riskymortgage.co.uk) default on the loan, then the hedge fund will pay Lloyds TSB
the value of the loan.
Thus Lloyds TSB has insurance against loan default. The hedge fund has the opportunity to
make a profit, so long as the firm does not default on the loan.
The riskier the loan, the higher will be the premium required on buying a credit default swap.
 WHY WOULD PEOPLE BUY CREDIT
DEFAULT SWAPS?

Hedge against risk.

Speculation e.g. risk is underpriced
• Arbitrage
 WHAT IS A TOTAL RETURN SWAP?

• A total return swap is a swap agreement in which one party makes payments
based on a set rate, either fixed or variable, while the other party makes
payments based on the return of an underlying asset, which includes both the
income it generates and any capital gains. In total return swaps, the underlying
asset, referred to as the reference asset, is usually an equity index, a basket of
loans, or bonds. The asset is owned by the party receiving the set rate payment.
 CREDIT DEFAULT SWAP OPTIONS

• Options is Also known as a credit default swaption, it is an option on a credit

default swap (CDS). A CDS option gives its holder the right, but not the
obligation, to buy (call) or sell (put) protection on a specified reference entity
for a specified future time period for a certain spread.
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