Sunday, April 22, 2007

How does a Credit Default Swap (CDS) Work?

Credit Default Swaps (CDS) are fast becoming the dominant vehicle for trading credit risk. In this piece, I'll go over the basic features of a standard CDS contract and why they are easier for many traders to utilize over cash bonds.

At the onset of a CDS contract, the buyer of the contract agrees to pay a fixed spread to the seller of the contract. For corporate CDS, the spread is paid quarterly, so if the spread agreed to is 40bps, the seller would pay 10bps per quarter. In exchange, the seller agrees to buy a specified bond (or other instrument) from the buyer at par in the event of a default. Most CDS contracts have a five-year term, but other terms are possible. If CDS are quoted without a term specified, assume its five years.

A CDS is a lot like an insurance policy. This is why CDS are also called protection. The spread paid by the buyer is like the insurance premium. If there is a default, the buyer is essentially made whole because s/he gets par for the bonds. Just like if you have homeowners insurance and you have a fire, the insurance policy pays you whatever your stuff is worth.

The CDS contract references a specific bond (or bank loan). For example, the 5-year Alltel CDS references the AT 7% '12. In the event of a default, the seller will be buying some bond which is pari-passu with the reference bond. The buyer of protection doesn't have to actually own this bond. In fact, the buyer of Alltel protection might be a bank with which Alltel has a credit line. The bank knows that if Alltel gets into trouble that the credit line will be drawn down. But they also know that the CDS contract spread will widen substantially, and they will have a profit in the contract. If Alltel actually defaults, they can buy the bond in the secondary market at a steep discount, then sell it to the seller of protection at par and make a huge profit.

CDS are also a vehicle for speculating on a credit. The buyer of protection is essentially short the credit, while the seller is long. Buying protection may be easier than actually finding the bonds to short. Similarly, selling protection may allow one to get exposure to a credit with greater leverage than would otherwise be the case. CDS also have no interest rate exposure, so someone who wants get get long or short a credit can do so without needing to work about hedging credit risk on either the short or long side.

In fact, selling CDS protection in consort with owning a LIBOR floating asset is exactly like being long a 5-year FRN (if you ignore things like financing costs). Think about it, with the 5-year FRN, you'd get paid LIBOR plus some spread so long as the credit doesn't default. If it does default, you suffer the difference between par and the recovery rate. The CDS/LIBOR combination has exactly the same payout structure. For that matter, selling protection is also very much like buying a 5-year fixed corporate and heding with a 5-year LIBOR swap. You wind up just collecting the spread. For this reason, the CDS should have a similar spread as cash bonds when compared to LIBOR swaps.

In practice, CDS can divert from cash bonds materially for a couple reasons. First, the CDS may be deeper than the cash bonds, and in a fast moving market, the CDS may appear to lead cash bonds. In reality, this may be that the cash bonds aren't trading. More recently, we've seen CDS widen in LBO situations while the cash bonds tighten. This is normally because of covenants in the cash bonds which will result in a make-whole call. This post on the Equity Office Properties transaction describes this possibility in more detail. The same thing happened recently with First Data Corp's LBO. Even with companies rumored, like Alltel, to be possible LBO candidates and have attractive covenants, the CDS tend to under perform cash bonds.

Another reason is a cute little arbitrage involving discount priced bonds. Take Ryland 5.375% '15. This bond was issued in January of 2005 when the 10-year was 50bps lower, and troubles in the housing market has pushed the spread about 75bps wider. As a result, this bond has a dollar price of $92. So let's say I buy the bond and buy protection on it. If it defaults, I get paid par for my bond. I make 8 points. If it doesn't default, and the carry isn't negative, nothing happens. I get paid the yield on the bond, but probably gave up all the spread buying the CDS. So basically its a trade that has a high probability of doing nothing, but a small possibility of producing a nice return. Upside with no downside = arbitrage. Anyway, so CDS that reference discount priced bonds tend to be wider than those referencing premium priced bonds.

Feel free to comment if you have questions, or e-mail me at accruedint AT gmail.com.

82 comments:

Anonymous said...

Your Ryland example confuses me. If you buy default protection with a CDS, isn't that a cost? So it's not really no downside, is it?

TDDG said...

Its a cost, but you aren't exposed to Ryland's credit any more. Now you are essentially earning a rate similar to 10-year LIBOR swaps, but you have this 8 point upside. So there is no downside versus just owning 10-year LIBOR swaps.

Anonymous said...

great explanation

Vivek said...

Could you short 10-year LIBOR swaps and then only have upside?

traderb said...

some small corrections:

at the onset of the trade, no payments are made. you are merely entering into a contract whereby you will pay a premium on a quarterly basis (monthly for EMG i think), with the first premium on the first IMM date after the settlement date of the contract (settle date is T+1 calendar days).

the cds contract references a specific bond (or loan occasionally) as you say, BUT you are allowed to deliver ANY bond or laon into the contract that is pari passu with the reference bond or loan...so if you use a regular senior unsecured bond as the reference obligation, you can deliver ANY senior unsecured bond or loan into the contract if it defaults (with a few non-iomportant technical excpetions).

as you mention, CDS is an excellent way to speculate on a credit...by buying protection, you don't have the hassle or cost of borrowing a bond in the repo market, and if you are selling protection, you can earn premium for taking exposure without having to fund a long position in bonds (hence, off-balance-sheet).

cds is VERY SIMILAR to owning a FRN, but not exactly. owning a FRN's requires you to finance them, if FRN's are trading at a price other than PAR it changes your carry and exposure slightly, and by selling CDS you are actually selling a Cheapest-To-Deliver (CTD) option on default, so you will pretty much be delivered the worst (cheapest) bond on default. But yes, when bonds are trading near PAR, bond and CDS spreads should be similar (but not unusual for them to be 25bps+ aparty either way).

And re: your discount bond "arbitrage" comment, remember that if you buy a bond at $92 that is paying L+125 (i dont know where Ryland trades), you are only earninng L+125 on the $92 price whereas you will be paying the CDS spread on PAR. Most of these "arbitrage" opportunities turn out to be nothing of the sort once you do the carry analysis.

TDDG said...

Traderb is right on all points. I was just trying to keep it simple. I figure most of my readers are either investment pros, students, or academics. So I sure hope that no one decides to start trading CDS based on my simplified description of how they work!

I did misspeak when I wrote "at the onset of the contract the buyer pays..." which I corrected.

I should have also mentioned the CTD thing, because that another reason why the CDS may deviate from the cash market.

As for the arbitrage I mentioned, obviously the carry differential is a big deal. This arb was pitched to me several months ago and I hadn't thought a lot about it since. I was only trying to give an example of reasons why the CDS might deviate from the cash market. I'd think that the arb only makes sense if you think a default is imminent. If it takes you 3 years to make 8 points, that isn't so great. In fact, on Ryland particularly, just glancing at it, I don't think the arb would work, because the bonds only pay a 5 3/8 coupon with around L+150 yield. The CDS are more like +190.

TDDG said...

Vivek:

Do you mean, could you go short the bond and sell protection on a premium bond and make the arb work the other way? I suppose, although I haven't heard of anyone doing that. It would all come down to the carry on it, I'd suspect.

traderb said...

yes, if a bond was trading at L+150, and you could borrow it at, say, L-20 in repo, then your net negative carry on that bond is -170bps. you could then sell protection at 190bps, and earn 20bps carry.

NOTE: this applies if the bond is trading at PAR.

NOTE 2: you are selling protection on the credit, not on a particular bond, as any bond (with some technical exclusions) is deliverable into the CDS. See my previous comment.


NOTE 3: you are at risk of the repo being pulled away from you or changing in price, so whilst you are funding the short in the bond at L-20 just now, that could change to L-250 (say) if the bond got "squeezy"...and that would then mean that your really smart +ve carry trade all of a sudden doesn't look so good...

tddg, nice blog you have btw. hope it didn't seem like i was criticizing earlier!

MING CHEN said...

I just stole a graph from Merrill Lynch credit derivative book, which illustrate the CDS valuation described in this post. You can see it in my blog here: http://pointlessly.blogspot.com/2007/04/how-to-price-cds.html

TDDG said...

Ming Chen:

That's a nice graphic. Thanks for the link.

Traderb:

No worries. I wasn't thinking when I wrote the part about the reference bond. Now I've fixed it.

Charlie said...

Do you have any other articles or info on credit derivatives pricing or trading? Been looking to find out more info on the player in the market... I've some interesting information on the following sites:
http://www.cawleyaxiomcds.com
http://www.cdsaxiomglobal.com

Know where I can find any additional info on the other players?

Anonymous said...

How does the accrual for premium payments work for performance valuation? As the seller and when you unwind the contract, do you get premium calculated up to the trade date at close?

TDDG said...

Anon: I'm not sure I understand your question. I'd think most people assume an interest accrual just like any other bond. Is that what you mean?

When you unwind the contract, the PV of the remaining payments is calculated and you get paid that amount. If, for example, the spread has tightened, then the PV will be higher and if its widened it will be lower. That's how people book profits.

Anonymous said...

i read the article..have any idea of minimum balance to open an institutional acct. in credit swaps (i'm owner of an institution

TDDG said...

I really don't know. On a single trade, you are allowed very large leverage, but I'm not sure what account size they want to see.

Anonymous said...

every time i call or email all the major (and minor ) market-maker banks they don't wanna talk to non-institutionals (who are'nt substansial,like my self) A position in a Single-name would cost the credit spread rate (bps)+ collateral which varies with respect to credit spread movement around a threshhold (+/- 2.5m)..that's not hard to achieve ,but they won't provide account info.

Anonymous said...

Hello, just like to have a quick confirmation on the lingo. When you long a CDS contract, does that mean that you are buying or selling credit protection?

TDDG said...

If you are long the contract, you are long protection. Or put another way, you are short the credit.

Anonymous said...

Do all CDS have to be linked to a specific debt issue?
I've heard that prices on CDS have been falling with companies in potential M&A deals. The prices are falling because investors feel the deal will collapse. Could you elaborate why that may be?
Thank you!

TDDG said...

By specific debt issue, do you mean a specific bond/loan or do you mean a specific company?

There are CDS contracts based on a series of companies. The CDX or ABX are examples (see www.markit.com).

CDS on specific companies reference a specific bond, but you can deliver any pari passu bond into the contract.

CDS spreads have been falling (which means it costs less to buy protection, or put another way, the people who were short protection are profiting) on some of the LBO names. Some have speculated this reflects the possibility that deals fail. Maybe. I think it also reflects a general improvement in HY spreads over the last couple weeks coupled with the liklihood that the LBO'ed company will wind up with less leverage.

Milind said...

I have a question regarding what happens to CDS swap premium accrual if there is a credit event inbetween CDS premium payment?

If CDS swap premium is to be paid every sept 20, dec 20, march 20 and june 20 and if there is a credit event on Oct 20 - what happens to 1 month's accrual of CDS swap premium?

Is protection buyer expected to pay one months swap premium to protection buyer in case credit event happens on Oct 20?

Milind said...

I have some more questions...
1) What is the linkage between list of possible credit events covered and pricing of the credit default swaps? For example if there are more events covered, does it mean that the protection is costlier?
2) If I define a CDS with 1 reference entity and 3 obligations of that entity - if 4th obligation of that entity defaults, does it constitute a credit event?
3) What decides recovery rate - a combination of reference entity + reference obligation + reference characteristic or some other criteria?

TDDG said...

Milind:

In terms of the accrual of swap premium, I believe the answer is yes. I don't know this for a fact, but I can't imagine it would be otherwise. If you own a bond with a coupon due on 7/1 and it defaults on 6/1, the 170 days of accrued are part of what you are owed. Now you may or may not get it in the course of the bankruptcy workout, but you are still due that accrued.

Your other questions are more complicated. I believe most corporate CDS that trade regularly have generically written definitions of default. My understanding is that CDS which cover more events are usually written on ABS or CDOs or something like that. I'm sure the CDS will have a higher spread if more default events are covered, but honestly I don't follow single name ABS CDS very closely.

CDS are written with a specific reference entity. If there was something within the capital structure which defaulted but the reference entitiy was somehow not in default, I think no event of default would be declared. Obviously that would be an unusual situation. If it were to happen that the company retired the reference entitiy, I believe anything pari passu with the original reference entitiy would count within the definition of default.

On recovery, under normal circumstances, the contract specifies that the buyer of protection "sells" the bond to the seller of protection at par. So recovery is essentially whatever the bond is worth at the moment. I know there have been fixed recovery contracts written but I don't know much about the technicals of those contracts.

Anonymous said...

Hello. Just market mechanics question but was curious to what drives the spread? Specifically last Winter, Avis guaranteed $1 billion in debt of its subsidiary of its debt, the spreads widened. I assumed that the guarantee meant the credit risk was lowered so how could the spread move higher?
Any clarification would be great.
Thank you.

TDDG said...

I don't know the Avis story specifically. If Avis backed subsidiary debt, the market might have viewed that as de facto increase in Avis' debt load, and therefore Avis is a weaker credit.

Anonymous said...

That makes sense. I was confusing the Avis guaranteed debt as being insured or at least secured with assets...which it is not. Thanks.

Anonymous said...

what's typical balance sheet requirement to participate in this privatespace? need 'third party access' like Treasury mkt..some said assets of half billion

Anonymous said...

Terrific blog. How are the capital gains on trades calculated? If I buy a single CDS for 50 BP and sell for 75 BP...I gane 25 BP. Assuming it is for $10 million of the underlying credit. What is the exact monetary gain? I assume it is an accrued interest. If you could provide an example I would greatly appreciate it. Thank you.

Anonymous said...

Terrific blog. How are the capital gains on trades calculated? If I buy a single CDS for 50 BP and sell for 75 BP...I gane 25 BP. Assuming it is for $10 million of the underlying credit. What is the exact monetary gain? I assume it is an accrued interest. If you could provide an example I would greatly appreciate it. Thank you.

Accrued Interest said...

You do a present value of the difference. Like if you are long protection at +50 then you want to sell at +75, you'd do a present value of all the payments you would have made at +50 discounted at +75.

Anonymous said...

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Sales&Trading community

Also, real quick.. does anyone here know the connection between yield curve analysis and spread trading?

I'm trying to research this

James said...

So the things to me that are unclear is who is it that is getting long all of this credit risk? Who is the facing counterparty? Given the broad market dislocations we are experiencing in huge swaths of the credit markets, I would expect that there is some systematic risk here that is not well or widely understood.

If, for instance, these trades are effected through investment banks' derivatives desks, as I expect they are, those banks would clearly be looking to hedge that risk for their own book. So who's taking that position? CDOs? Hedge funds? What if those blow up as many have been doing? Does the trade come back to the investment bank?

Anonymous said...

"For corporate CDS, the spread is paid quarterly, so if the spread agreed to is 40bps, the seller would pay 10bps per quarter."

should this not read - the buyer pays 10bps per quarter?

Anonymous said...

Accrued Interest,

I've been looking for an answer to this to no avail, would greatly appreciate one:

In event of default, does the insurer have to pay total nominal amount of (oversubsribed) CDS, or only the total of outstanding defaulted underlying bonds of the company that went belly up?

That kind of makes a big difference, don't it?

Accrued Interest said...

The seller of protection has to buy a pre-defined amount of a bond at par.

You are refering to instances where the total amount of CDS outstanding is greater than the reference entity's debt outstanding?

Anonymous said...

Yes, total amount of CDS greater than debt outstanding.

I was under the impression that this was a common event. In Delphi's case I thought they did some special processing.

Basically does a buyer of CDS even know how many of the same debt the insurer has already insured?

I guess the question is, does the CDS buyer have to cough up the bonds when the company defaults, or else won't be able to collect anything?

Same question: is it possible to say issue $10 billion of nominal CDS coverage for total outstanding reference debt of only $1 billion, and if so, do the holders of CDS get to hold the $10 billion bag or the issuer has to pay the whole $10 billion?

Anonymous said...

This is a great blog! My question relates to CDS indexes. I have read that when indexes are tightening I should be "long" to make money. Does this mean I should be long the protection or long the credit?

Accrued Interest said...

Long protection is short credit and vice versa. So if spreads are tightening, you want to be short protection/long credit.

Anonymous said...

Hi, I was reading a comment given by an indexes trader, and he said that his accounts were putting shorts on. What does it mean to "put a short on". Does it always mean to buy protection?

Accrued Interest said...

Well, to take him literally, it would mean his accounts were shorting the CDS index, which is effectively long credits.

Unfortunately, people can be loose with their language, so without the context I couldn't be too sure what he meant.

Typeo said...

What exactly happens on an unwind? Let's say you're long protection initially and then unwind. Do you actually enter into a separate short protection contract?

So the spread has increased compared to your initial spread and you have profit. When you unwind do you actually get the difference in premium values as cash all at once?

Thanks!

Avatar said...

Do you have a private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk. To do this they buy a credit default swaps (CDS) to protect themselves in the event you have lost your home due to repossession. CDS and PMI are the same thing. If you don't like them I suggest you tell all of your friends what they really are and then don't buy a home with less than 20 percent down. If you don't you build to the the so called CDS problem. http://nomedals.blogspot.com

Jim said...

I would like to know what happens when the seller defaults(bankruptcy) and cannot pay? I have never seen anything with all up and no downside.

Benjamin said...

Derivatives Week

N.Y. AG Probes Brokers On CDS

New York Attorney General Andrew Cuomo has subpoenaed eight interdealer brokers to produce data and other communication regarding their activities in credit default swap trading. People familiar with the situation say Cuomo, as well as the Securities and Exchange Commission in a separate inquiry, are looking to identify dealers who during August and September may have spread false information to manipulate CDS prices. Two of the exchanges uncovered were emails between Marcos Brodsky, a partner at Phoenix Partners, and Roman Shukhman, a credit derivatives trader at JPMorgan. According to documents, the first email from Brodsky suggested Goldman Sachs was looking to sell a CDS index position, while the second one, from Shukhman asked about seeking notification for when a Deutsche Bank had entered the market.

RICO said...

Rico R says,

The Solution is, a "reversed Ponzi" scheme. The best way to recap the banks while you give relief to the consumer, directly.

Tom said...

The more I look at these credit derivatives, especially CDS, I keep picturing Howie Mandel saying "Deal or No Deal", with the contestant being the CDS insured and the bank being, well, the bank (the issuer of the CDS). The contestant can stop the game and cut a deal for a profit, if the bank agrees to buy it back. Or he can hold onto the CDS and go for the big money, the only problem is that now the banks are lacking liquidity, they don't have cash to cover the payout value.

Memo said...

I found a nice graphic about how a CDS works:
http://www.nytimes.com/imagepages/2008/02/17/business/20080217_SWAP_1_GRAPHIC.html

Cheers

Memo

Anonymous said...

Why do we quote CDS price as "CDS Spread" or "CDS Premium"? Is it a spread over its reference cash bond? or anything else?

Accrued Interest said...

Its not really a spread. If the quote is 100bps, and you buy $10 million of protection, then the cost of $100,000 per year.

Anonymous said...

Yeah, I know that. I just don't understand why CDS price is called as CDS Spread?

Accrued Interest said...

It isn't really a spread over anything so I honestly can't say. Probably just because bond guys are so used to talking in spreads.

Anonymous said...

Hi. I'm confused about something. Generally when CDS spreads tighten, it's seen as a good thing - risk decreasing, etc. But if I have bought a CDS at (say) 50bps and it tightened to 40bps, haven't I made a loss? So by this logic, buyers of CDS want spreads to go up?

Thanks very much!

Accrued Interest said...

Buyers of CDS are buying protection. Yes, they want spreads to widen.

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