Credit default swaps

In a credit default swap (CDS), the protection seller, the provider of credit protection,
receives a payment in return for the obligation to make a payment that is contingent
on the occurrence of a credit event for a reference entity. The size of the payment
reflects the decline in value of a reference asset issued by the reference entity. A
credit event is normally a payment default, bankruptcy or insolvency, failure to pay,
or receivership. It can also include a restructuring or a ratings downgrade. A
reference asset can be a loan, security, or any asset upon which a ‘dealer price’ can
be established. A dealer price is important because it allows both participants to a
transaction to observe the degree of loss in a credit instrument. In the absence of a
credit event, there is no obligation for the protection seller to make any payment,
and the seller collects what amounts to an option premium. Credit hedgers will
receive a payment only if a credit event occurs; they do not have any protection
against market value declines of the reference asset that occur without a credit event.
Figure 11.2 shows the obligations of the two parties in a CDS.

In the figure the protection buyer looks to reduce risk of exposure to XYZ. For
example, it may have a portfolio model that indicates that the exposure contributes
excessively to overall portfolio risk. It is important to understand, in a portfolio
context, that the XYZ exposure may well be a high-quality asset. A concentration in
any credit risky asset, regardless of quality, can pose unacceptable portfolio risk.
Hedging such exposures may represent a prudent strategy to reduce aggregate
portfolio risk.
The protection seller, on the other hand, may find the XYZ exposure helpful in
diversifying its own portfolio risks. Though each counterparty may have the same
qualitative view of the credit, their own aggregate exposure profiles may dictate
contrary actions.
If a credit event occurs, the protection seller must pay an amount as provided in
the underlying contract. There are two methods of settlement following a credit event:
(1) cash settlement; and (2) physical delivery of the reference asset at par value. The
reference asset typically represents a marketable obligation that participants in a
credit derivatives contract can observe to determine the loss suffered in the event of
default. For example, a default swap in which a bank hedges a loan exposure to a
company may designate a corporate bond from that same entity as the reference
asset. Upon default, the decline in value of the corporate bond should approximate
the loss in the value of the loan, if the protection buyer has carefully selected the
reference asset.
Cash-settled transactions involve a credit event payment (CEP) from the protection
seller to the protection buyer, and can work in two different ways. The terms of the
contract may call for a fixed dollar amount (i.e. a ‘binary’ payment). For example, the
contract may specify a credit event payment of 50% upon default; this figure is
negotiated and may, or may not, correspond to the expected recovery amount on the
asset. More commonly, however, a calculation agent determines the CEP. If the two
parties do not agree with the CEP determined by the calculation agent, then a dealer
poll determines the payment. The dealer poll is an auction process in which dealers
‘bid’ on the reference asset. Contract terms may call for five independent dealers to
bid, over a three-day period, 14 days after the credit event. The average price that
the dealers bid will reflect the market expectation of a recovery rate on the reference
asset. The protection seller then pays par value less the recovery rate. This amount
represents the estimate of loss on assuming exposure to the reference asset. In both
cases, binary payment or dealer poll, the obligation is cash-settled because the
protection seller pays cash to settle its obligation.
In the second method of settlement, a physical settlement, the protection buyer
may deliver the reference asset, or other asset specified in the contract, to the
protection seller at par value. Since the buyer collects the par value for the defaulted
asset, if it delivers its underlying exposure, it suffers no credit loss.
CDSs allow the protection seller to gain exposure to a reference obligor, but absent
a credit event, do not involve a funding requirement. In this respect, CDSs resemble
and are economically similar to standby letters of credit, a traditional bank credit
product.
Credit default swaps may contain a materiality threshold. The purpose of this is to
avoid credit event payments for technical defaults that do not have a significant
market impact. They specify that the protection seller make a credit event payment
to the protection buyer, if a credit event has occurred and the price of the reference
asset has fallen by some specified amount. Thus, a payment is conditional upon a
specified level of value impairment, as well as a default event. Given a default, a
payment occurs only if the value change satisfies the threshold condition.
A basket default swap is a special type of CDS. In a basket default swap, the
protection seller receives a fee for agreeing to make a payment upon the occurrence
of the first credit event to occur among several reference assets in a basket. The
protection buyer, in contrast, secures protection against only the first default among
the specified reference assets. Because the protection seller pays out on one default,
of any of the names (i.e. reference obligors), a basket swap represents a more
leveraged transaction than other credit derivatives, with correspondingly higher fees.
Basket swaps represent complicated risk positions due to the necessity to understand
the correlation of the assets in the basket. Because a protection seller can lose on
only one name, it would prefer the names in the basket to be as highly correlated as
possible. The greater the number of names in the basket and the lower the correlation
among the names, the greater the likelihood that the protection seller will have to
make a payment.
The credit exposure in a CDS generally goes in one direction. Upon default, the
protection buyer will receive a payment from, and thus is exposed to, the protection
seller. The protection buyer in a CDS will suffer a default-related credit loss only if
both the reference asset and the protection seller default simultaneously. A default
by either party alone should not result in a credit loss. If the reference entity defaults,
the protection seller must make a payment. If the protection seller defaults, but the
reference asset does not, the protection purchaser has no payment due. In this event,
however, the protection purchaser no longer has a credit hedge, and may incur
higher costs to replace the protection if it still desires a hedge. The protection seller’s
only exposure to the protection buyer is for periodic payments of the protection fee.
Dealers in credit derivatives, who may have a large volume of transactions with other
dealers, should monitor this ‘receivables’ exposure. 315