This document discusses credit default swaps (CDS), including: - CDS are a type of derivative that functions as a form of default insurance on a debt obligation. - In a basic CDS transaction, the protection buyer makes periodic payments to the protection seller, and in exchange receives a payoff if the reference entity defaults or experiences another credit event. - CDS markets grew rapidly in the early 2000s but also contributed to the 2008 financial crisis when American International Group's massive CDS exposures led to its government bailout.

1. Credit Default Swap (CDS)
Finanzas Empresariales II
Omar Pernas López-Sarry

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Index
• Introduction
• Credit Default Swap
• Example
• Conclusions
• Bibliography

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Index
• Introduction
• Credit Default Swap
• Example
• Bibliography

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What’s a financial derivative?
Derivatives are financial instruments whose payoffs
derive from other, more primitive financial variables such
as a stock price, a commodity price, an index level, an
interest rate, or an exchange rate.

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Composition of global derivatives
contracts by trading arrangement as at
the end of 2014 by outstanding gross
notional value

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How can derivatives be used?
• Forwards and futures: to hedge an existing
market exposure.
• Options: to obtain downside protection to an
exposure even while retaining upside
potential.
• Swaps: to transform the nature of an
exposure.
• Credit derivative: to obtain insurance
against events such as default.

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Size of global OTC derivatives
markets by outstanding gross
notional value

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What’s gross notional outstanding
value?
Notional outstanding refers to the principal amount of the contracts.
• If a forward contract calls for the delivery of 1,000 oz of gold at a
price of $1,800/oz, the notional outstanding in the contract is $(1,
800 × 1, 000) = $1.80 million.
• If an option gives the holder the right to buy 10,000 shares of
Google at $500/ share, the notional outstanding in the contract is
$(10, 000 × 500) = $5 million.
• If a swap calls for the exchange of floating cash flows for fixed cash
flows on a principal of $100 million, the notional outstanding in the
swap is $100 million.

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What’s a credit derivative?
Credit derivatives are derivatives written
on the credit risk of an underlying reference
entity. Isolate credit risk from other risks
present in an asset. Are off-balance-sheet
instruments.

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Isolation and separate
trading of credit risk

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Credit Derivative Market Growth

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Types of credit derivatives
• Credit Default Swap (CDS)
• Total Return Swap
• Constant Maturity Credit Default Swap (CMCDS)
• First to Default Credit Default Swap
• Portfolio Credit Default Swap
• Secured Loan Credit Default Swap
• Credit Default Swap on Asset Backed Securities
• Credit default swaption
• Recovery lock transaction
• Credit Spread Option
• CDS index products

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Index
• Introduction
• Credit Default Swap
• Example
• Bibliography

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CDS: definition
A Credit Default Swap (CDS) is a kind of
insurance against credit risk.

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How does a CDS work?
Protection buyer
(short position)
Protection seller
(long position)
Bp per annum
Contingent
payment
Credit event
• Municipal bonds
• Emerging market bonds
• Mortgage-backed
securities
• Corporate debt
Reference
entity

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Three main types of CDS
• Single name: The reference entity is an individual
corporation, bank, or government.
• Index: CDS referring to multiple constitutent entities
in the index with each entity having an equal share of
the notional amount. The degree of standardisation is
highest for these contracts.
• Basket CDS: CDS with more than one reference entity
(typically between three and one hundred names).
Specific types include first-to-default CDS, full basket
CDS, untranched basket and tranched basket known as
a synthetic CDO.

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Types of credit events
• Bankruptcy: where the reference entity becomes bankrupt
or suffers an analogous.
• Failure to pay: where the reference entity fails to make a
payment of interest or principal.
• Obligation default: where the reference entity defaults on
one of its obligations.
• Repudiation/moratorium: where the reference entity
repudiates or declares a moratorium over some or all of its
debts.
• Restructuring: where the reference entity arranges for
some or all of its debts to be restructured causing a material
change in their creditworthiness.

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CDS features
Size
Averaging $25 to $50 million per
transaction.
Time to maturity 1 to 10 years.
Transaction
method
Direct contracting and trading
between the seller and the buyer
Guarantees
required
Not if rated >= AA
Secondary
market
Existent
Settlement Whole losses or gains at maturity
Guarantying
institution
The own contracting parties
Contract
compliance
Physical delivery or cash settlement

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CDS uses: hedging and Speculation
• An individual or company that is exposed
to a lot of credit risk can shift some of
that risk by buying protection in a CDS
contract.
• CDS provide a very efficient way to take a
view on the credit of a reference entity.

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CDS: Market risks
• The market for CDS is OTC and unregulated.
• Contracts often get traded so much that it is hard
to know who stands at each end of a transaction.
• Counterparty risk.
• The possibility that a widespread downturn in the
market could cause massive defaults and
challenge the ability of risk buyers to pay their
obligations.
• Leverage.

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Index
• Introduction
• Credit Default Swap
• Example
• Bibliography

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AIG’s involvement in mortgage backed
securities (MBS)
Protection buyer:
Lenders, investors
Protection seller:
AIG
Bp per annum
Contingent
payment
Credit event:
Sub-prime crisis
Reference entity
Mortgage
Backed
Obligations
(MBO)
Returns on
different
tranches
Borrowers
Borrowers
Principal +
Interest
$180 billion
bailout

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The Big Short
https://www.youtube.com/watch?v=Cxjdj5_
5yNM

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CDS from business newspaper

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The evolution of average 5-years
weekly CDS spreads (bp) for strong-
economy countries

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The evolution of average 5-years
weekly CDS spread (bp) for PIIGS

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Index
• Introduction
• Credit Default Swap
• Example
• Bibliography

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Bibliography
• The J.P. Morgan guide to credit derivatives
• Credit derivatives: an overview, Federal
Reserve of Atlanta
• Derivatives in Financial Market Development,
International Growth Centre, February 2013
• Credit Default Swaps and counterparty risk,
European Central Bank, August 2009