Rupai Ghosh

Let’s Understand
Credit Default
Swaps (CDS)
Betting on Default?
 Rupai Ghosh

What is a Credit Default Swap?

Imagine you lend money to a friend. A CDS is like an insurance
policy for that loan. You (the buyer) pay a small fee (premium) to a
friend (the seller) who agrees to cover your losses if the borrower
(your friend) defaults on the loan (credit event).

A Credit Default Swap (CDS) is a financial derivative that allows

an investor to "swap" or transfer the credit risk of a debt
instrument, such as a bond or loan, to another party in
exchange for regular payments.

The seller of the CDS agrees to make payments to the buyer if

the underlying asset defaults.

It provides protection to the buyer against the risk of default

by the issuer of the underlying debt instrument.
 Rupai Ghosh

How Does a CDS Work?

The CDS contract has a set term, just like an insurance policy.

Parties Involved:

Buyer (Protection Buyer): The entity seeking protection

against the credit risk.

Seller (Protection Seller): The entity providing the protection

in exchange for premium payments.

Payment Structure:

The buyer pays a periodic premium to the seller.

If a credit event occurs, the seller compensates the buyer for

the loss in the value of the underlying debt instrument.
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Credit Event
A specific event that triggers the obligation of the CDS seller to
make payments.

Not every missed payment triggers a CDS. The contract defines

specific events (credit events) that would cause the seller to
make a payout. Typically includes,

Default on a loan

Loan restructuring (changing terms due to financial difficulty)

Bankruptcy filing

Obligation acceleration (demanding full repayment

immediately)
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Managing Credit Exposure with CDS

Risk Mitigation:

CDS allows investors to hedge against credit risk without

directly owning the underlying debt instrument.

By using CDS, investors can protect themselves against the

potential default of the issuer, minimizing credit exposure
.
Diversification:

CDS provides a tool to diversify credit risk across various issuers

and debt instruments.

Investors can manage credit exposure more effectively by

spreading risk through a portfolio of CDS contracts.
 Rupai Ghosh

Settlement Protocols for CDS

When a credit event happens, the CDS contract needs to be settled.

Cash Settlement:

In cash settlement, the buyer receives a cash payment from the

seller upon a credit event.

The payment amount is based on the market value of the

reference obligation after the credit event.

Physical Settlement:

In physical settlement, the buyer takes ownership of the

reference obligation from the seller.

The buyer receives the face value of the reference obligation,

which may be lower than the market value post-credit event.
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Settlement Protocols for CDS

Auction Process:

For physical settlement, an auction is held to determine the

final price of the reference obligation.

Market participants submit bids and offers to establish a fair

market price for the defaulted debt.

Settlement Timing:

Settlement typically occurs within a specified timeframe after the

credit event is declared.

Timely settlement ensures that the buyer receives protection

against the credit default.
 Rupai Ghosh

Factors that Influence CDS

Credit Quality of the Issuer:

The creditworthiness of the entity issuing the debt

instrument directly impacts the pricing and demand for CDS
contracts.

Higher credit risk associated with the issuer generally results in

higher CDS premiums.

Issuer-Specific Events:

Financial events or news related to the issuer, such as

changes in credit ratings, financial performance, or significant
corporate events, can affect CDS pricing.

Negative developments can lead to an increase in the cost of

CDS contracts.
 Rupai Ghosh

Factors that Influence CDS

Underlying Debt Structure:

The specific characteristics of the underlying debt

instrument, such as its maturity, coupon rate, and seniority, can
impact the pricing and demand for CDS.

Bonds or loans with longer maturities, higher coupon rates, or

subordinated status may carry higher credit risk, affecting CDS
pricing.

Market Conditions:

Economic factors and market sentiment influence the pricing

and availability of CDS.

Market volatility, economic indicators, and investor

perceptions can significantly impact the cost and demand for
CDS contracts.
 Rupai Ghosh

The Financial Crisis and CDS

CDSs played a significant role in the 2008 financial crisis. The over-
the-counter nature of CDSs allowed for complex and ambiguous
transactions. During the 2008 financial crisis, the widespread use of
CDS on mortgage-backed securities for speculation amplified the
impact of the crisis. Banks gave out lots of loans to people who
couldn't pay them back, making the financial system very shaky.
Some banks had sold lots of CDS to other banks, thinking they
were protected. But when many people couldn't pay back their
loans, the banks that sold CDS had to pay out lots of money, making
the problem worse. The complexity of CDS contracts and the ability
to buy and sell them on multiple borrowers made it hard to track
the overall risk in the system. The use of CDS made the financial
crisis spread from one bank to another, making it a big problem
for the whole financial system.
 Rupai Ghosh

Regulatory Environment for CDS

Oversight: Regulatory authorities like SEC and ESMA monitor

CDS markets for transparency and stability.

Reporting: Market participants must report CDS transactions to

enhance market surveillance.

Clearing: Regulations may mandate central clearing to reduce

counterparty risk and ensure orderly settlements.

Capital Adequacy: Rules ensure that banks have sufficient

reserves to cover potential losses from CDS activities.
 Rupai Ghosh

Example
Investor Joe who owns bonds from a company but is worried that
the company might not be able to pay back the money. He wants to
protect his investment. Along comes a CDS Seller who is willing to
help Joe. They agree on a deal where Joe pays a small amount
regularly to the CDS Seller. In return, if the company defaults on its
bonds, the CDS Seller will pay Joe the full value of the bonds. It's like
having an insurance policy on his investment. This arrangement helps
Investor Joe protect his investment in case the company gets into
financial trouble and cannot pay back its bonds. If the company stays
financially strong and doesn't default, Joe pays the CDS Seller the
agreed small amounts, like a safety net that he didn't have to use.
 Rupai Ghosh

Key Takeaways
CDS provides mechanism to hedge against credit risk.

The occurrence of a credit event triggers the CDS contract.

Regulatory oversight aims to minimize systemic risk associated

with CDS.

Conclusion
Credit Default Swaps are a valuable tool for managing credit risk in
the financial system. However, they can be complex and also pose
risks if not properly understood and regulated. It is important for
investors to be aware of the potential implications of CDSs before
entering into such contracts.
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Rupai Ghosh