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2020 Curriculum CFA Program Level II Fixed Income

Credit Default Swaps

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Introductions

A credit derivative is a derivative instrument in which the underlying is a measure of a borrower’s credit quality. Four types of credit derivatives are (1) total return swaps, (2) credit spread options, (3) credit-linked notes, and (4) credit default swaps, or CDS. The first three are not frequently encountered. CDS have clearly emerged as the primary type of credit derivative and, as such, are the topic of this reading. In a CDS, one party makes payments to the other and receives in return the promise of compensation if a third party defaults.

In any derivative, the payoff is based on (derived from) the performance of an underlying instrument, rate, or asset that we call the underlying. For a CDS, the underlying is the credit quality of a borrower. At its most fundamental level, a CDS provides protection against default, but it also protects against changes in the market’s perception of a borrower’s credit quality well in advance of default. The value of a CDS will rise and fall as opinions change about the likelihood of default. The actual event of default might never occur.

Derivatives are characterized as contingent claims, meaning that their payoffs are dependent on the occurrence of a specific event or outcome. For an equity option, the event is that the stock price is above (for a call) or below (for a put) the exercise price at expiration. For a CDS, the credit event is more difficult to identify. In financial markets, whether a default has occurred is sometimes not clear. Bankruptcy would seem to be a default, but many companies declare bankruptcy and some ultimately pay all of their debts. Some companies restructure their debts, usually with creditor approval but without formally declaring bankruptcy. Creditors are clearly damaged when debts are not paid, not paid on time, or paid in a form different from what was promised, but they are also damaged when there is simply an increase in the likelihood that the debt will not be paid. The extent of damage to the creditor can be difficult to determine. A decline in the price of a bond when investors perceive an increase in the likelihood of default is a very real loss to the bondholder. Credit default swaps are designed to protect creditors against such credit events. As a result of the complexity of defining what constitutes default, the industry has expended great effort to provide clear guidance on what credit events are covered by a CDS contract. As with all efforts to write a perfect contract, however, no such device exists and disputes do occasionally arise. We will take a look at these issues later.

This reading is organized as follows: Section 2 explores basic definitions and concepts, and Section 3 covers the elements of valuation and pricing. Section 4 discusses applications. Section 5 provides a summary. 

Learning Outcomes

The member should be able to:

  • describe credit default swaps (CDS), single-name and index CDS, and the parameters that define a given CDS product;
  • describe credit events and settlement protocols with respect to CDS;

  • explain the principles underlying, and factors that influence, the market’s pricing of CDS;

  • describe the use of CDS to manage credit exposures and to express views regarding changes in shape and/or level of the credit curve;

  • describe the use of CDS to take advantage of valuation disparities among separate markets, such as bonds, loans, equities, and equity-linked instruments. 

Summary

This reading on credit default swaps provides a basic introduction to these instruments and their markets. The following key points are covered:

  • A credit default swap (CDS) is a contract between two parties in which one party purchases protection from another party against losses from the default of a borrower for a defined period of time.

  • A CDS is written on the debt of a third party, called the reference entity, whose relevant debt is called the reference obligation, typically a senior unsecured bond.

  • A CDS written on a particular reference obligation normally provides coverage for all obligations of the reference entity that have equal or higher seniority.

  • The two parties to the CDS are the credit protection buyer, who is said to be short the reference entity’s credit, and the credit protection seller, who is said to be long the reference entity’s credit. The seller (buyer) is said to be long (short) because the seller is bullish (bearish) on the financial condition of the reference entity.

  • The CDS pays off upon occurrence of a credit event, which includes bankruptcy, failure to pay, and, in some countries, restructuring.

  • Settlement of a CDS can occur through a cash payment from the credit protection seller to the credit protection buyer as determined by the cheapest-to-deliver obligation of the reference entity, or by physical delivery of the reference obligation from the protection buyer to the protection seller in exchange for the CDS notional.

  • A cash settlement payoff is determined by an auction of the reference entity’s debt, which gives the market’s assessment of the likely recovery rate. The credit protection buyer must accept the outcome of the auction even though the ultimate recovery rate could differ.

  • CDS can be constructed on a single entity or as indexes containing multiple entities.

  • The fixed payments made from CDS buyer to CDS seller are customarily set at a fixed annual rate of 1% for investment-grade debt or 5% for high-yield debt.

  • Valuation of a CDS is determined by estimating the present value of the protection leg, which is the payment from the protection seller to the protection buyer in event of default, and the present value of the payment leg, which is the series of payments made from the protection buyer to the protection seller. Any difference in the two series results in an upfront payment from the party having the claim on the greater present value to the counterparty.

  • An important determinant of the value of the expected payments is the hazard rate, the probability of default given that default has not already occurred.

  • CDS prices are often quoted in terms of credit spreads, the implied number of basis points that the credit protection seller receives from the credit protection buyer to justify providing the protection.

  • Credit spreads are often expressed in terms of a credit curve, which expresses the relationship between the credit spreads on bonds of different maturities for the same borrower.

  • CDS change in value over their lives as the credit quality of the reference entity changes, which leads to gains and losses for the counterparties, even though default may not have occurred or may never occur.

  • Either party can monetize an accumulated gain or loss by entering into an offsetting position that matches the terms of the original CDS.   

  • CDS are used to increase or decrease credit exposures or to capitalize on different assessments of the cost of credit among different instruments tied to the reference entity, such as debt, equity, and derivatives of debt and equity.