CDS (credit default swaps)

A credit default swap is a privately negotiated (or over-the-counter) agreement used to transfer credit exposure between two counterparties (in other words, CDS can also be used to gain exposure to credit risk). It is 'a bilateral financial contract in which a protection buyer makes...periodic payments ...to a protection seller, in return for a contingent payment if a predefined credit event occurs in the reference credit': Eternal Global Master Fund Ltd. v. Morgan Guaranty Trust co. of New York (2004)

The protection buyer purchases credit protection and is said to short the credit exposure. The protection seller sells credit protection and is said to long the credit exposure. While the risk profile of a CDS is similar to investing in the corporate bonds of the reference entity, a CDS does not require initial funding of the notional amount. By entering into a CDS the protection buyer can create a short position in the reference credit.The protection seller receives periodic payments (the spread i.e. the annual price of protection quoted in bps) from the protection buyer as the premium of the protection. These payments are usually paid quarterly, in arrears.

CDS and insurance

However, CDS is different from an insurance in that 'CDSs do not, and are not meant to, indemnify the buyer of protection against loss' and 'indemnity is insurance concept. See, e.g. McAnarney v Newark Fire Ins. Co.(citation omitted). CDSs are not insurance for numerous reasons. Most significantly, there is no requirement that the protection buyer own the asset on which it is buying protection or that it suffer any loss...Other common features of CDSs that distinguish them from insurance include: (i) the absence of a requirement that the buyer provide proof of loss as a condition to payment; (ii) payment upon settlement that may be more than the loss (if any) suffered by the buyer; (iii) the absence of rights of subrogation; and (iv) differences in accounting, tax, bankruptcy and othre regulatory treatment': Amicus curriae brief in Aon Financial Products v Societe Generale (2006)

credit events

The cash flow paid to the protection buyer is contingent on the occurrence of a “credit event” (and other conditions specified e.g. those set out in ISDA 2003 credit derivative definitions including notice of the credit event and notice of the sources of information). Credit events include:

Failure to pay (interest or principal when due)
Bankruptcy
Obligation acceleration
Obligation default
Repudiation/moratorium
Restructuring

However, the common ones are Bankruptcy, Failure to Pay and Restructuring. Some market participants exclude Restructuring as a credit event. For more detail on Restructuring please see this article. If no credit event occurs during the term of the CDS, the protection buyer continues to pay the premium until the maturity of the CDS.

settlement

Two things have to happen before a settlement. First, there has to be a “credit event” discussed below. Secondly the “Conditions to Settlement” (Section 3.2 e.g. Credit Event Notice, Notice of Publicly Available Information and, where applicable, Notice of Physical Settlement) must be satisfied.

Settlement can be physical or cash. In a cash-settled situation, payment to the buyer of protection is calculated by multiplying the notional amount of the swap by the difference between par and market price of the obligations of the reference entity. In a physically settled swap, the protection buyer will delivered the obligations of the reference entity to the protection seller in exchange for the par value of the obligations. If the agreed settlement is physical, the parties may agree that the obligations that can be delivered include:

Direct obligations of the reference entity
Guaranteed obligations of the subsidiary of the reference entity
Guarantee of the reference entity on the obligations of a third party

The parties may also agree on the type (i.e. payment, bonds or loans) as well as the characteristics (e.g. subordination, currency, denomination) of obligations to be delivered.

participants

The CDS market offers e.g. banks a way to transfer risk without transferring loan assets out of their balance sheet and without the knowledge or involvement of the borrowers. The CDS market is increasingly used by e.g. insurance companies (as protection sellers) to enhance investment yields.

pricing

Pricing of CDS is closely related to bond yield spreads or excess yields to risk-free government bonds and depends on a number of factors such as (a) probability of default (b) likely rate of recovery (c) other considerations such as liquidity and market sentiment.

Recently, CDS spread has also been closely linked with LBO (leveraged buy-out) or rumour thereof. As an LBO is likely to increase the reference entity's debt level substantially thus lower its credit rating. Rumour of LBO could send the CDS spread higher as bid speculation intensifies.

documentation

Confirmations (i.e. the documents evidencing the trades) of CDS typically incorporate provisions of the ISDA 2003 credit derivative definitions. Master confirmation agreements between dealers are also available in many advanced markets such as New York, London and Tokyo. The relevant provisions of a physically settled single reference entity CDS are these (by way of illustration only - incomplete).

derivativeslawyer.com

Last updated January 2007

The above notes are intended to provide only general outlines and, where applicable, should be read in conjunction with, and are qualified in their entirety by, the full provisions of the relevant ISDA provisions and definitions. They should never be used in place of professional advice. We accept no responsibility for any loss arising from any action taken or not taken by anyone using this material or using this material in conjunction with any ISDA documentation (where applicable) in reliance thereof.

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