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2022 Curriculum CFA Program Level II Fixed Income

Credit Default Swaps

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Introduction

Derivative instruments in which the underlying is a measure of a borrower’s credit quality are widely used and well established in a number of countries. We explore basic definitions of such instruments, explain the main concepts, cover elements of valuation and pricing, and discuss applications.

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 the 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

  • 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 CDS pays off upon occurrence of a credit event, which includes bankruptcy, failure to pay, and, in some countries, involuntary 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. Bespoke CDS or baskets of CDS are also common.
  • 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 payment leg, which is the series of payments made from the protection buyer to the protection seller, and the present value of the protection leg, which is the payment from the protection seller to the protection buyer in event of default. If the present value of the payment leg is greater than the present value of the protection leg, the protection buyer pays an upfront premium to the seller. If the present value of the protection leg is greater than the present value of the payment leg, the seller pays an upfront premium to the buyer.
  • 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. CDS spreads approach zero as the CDS approaches maturity.
  • 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.