Credit Default Swap

Every derivative in the syllabus takes its value from something: an interest rate, a currency pair, an equity index, a commodity. A credit default swap takes its value from whether a particular borrower pays.

The structure is simple and the workbook states it in one sentence. One counterparty, the buyer of protection, makes a regular periodic payment to the other counterparty, the seller of protection. In exchange, the protection seller agrees to pay the protection buyer any loss in value on the specified reference obligation if a credit event — for example, default — occurs during the life of the CDS contract.

So it behaves like insurance on a bond. The buyer pays a premium stream; the seller pays out if the borrower fails.

It is called a swap because the two legs are exchanged over a period — a stream of payments against a contingent stream — which is what puts it in the swap family rather than the forward or option family. But note the asymmetry: the seller's obligation is contingent and the buyer's is not, which makes it feel far more like insurance than like an interest rate swap.

Four things define a CDS: the reference obligation (which bond or loan), the notional amount (how much is protected), the spread (the premium, quoted in basis points a year and paid periodically), and the credit events that trigger it.

The premium is quoted in basis points of the notional per year. A widening spread means the market thinks default is more likely — which is why CDS spreads are read as a market price of credit risk, quite apart from anyone actually using them.

On a credit event, settlement covers the loss in value on the reference obligation: the protection buyer is made whole for the difference between face value and what the obligation is actually worth, the recovery.

CDS is an OTC product, negotiated bilaterally, and the workbook places it outside the four generic derivative types (forward, futures, swap, option) as a separate note — "additionally, credit risk as underlying". It matters to a currency derivatives candidate for two reasons: it is the standard example of an underlying that is neither a price nor a rate, and it is the instrument most associated with the 2008 financial crisis, where a default by one or two large counterparties produced a domino effect — the reason regulators have since pushed derivatives towards exchange trading with centralised clearing.

Annual premium = Notional × Spread (in basis points) ÷ 10,000

Payout on a credit event = Notional × (1 − Recovery rate)

Net outcome to the protection buyer
  = Payout − Total premiums paid to the date of the credit event

BIS notional amounts outstanding in OTC derivative products, June 2023 (USD billion):

Interest rate contracts                       573,697
Foreign exchange contracts                    120,250
Credit derivatives (including CDS)             10,122
Equity-linked contracts                         7,838
Commodity contracts                             2,244
Other                                             593
Total                                         714,744

An Indian bank holds Rs 50 crore of a corporate bond and is uneasy about the issuer. It buys five-year protection from another bank at a quoted spread of 180 basis points a year.

The premium leg:

50,00,00,000 × 180 ÷ 10,000 = Rs 90,00,000 a year

Rs 90 lakh a year, or Rs 22.5 lakh a quarter, paid whether or not anything happens.

The contingent leg. Three years in, the issuer defaults. The bond is worth 40 paise in the rupee — a recovery rate of 40%.

Loss in value = 50,00,00,000 × (1 − 0.40) = Rs 30,00,00,000

The protection seller pays the bank Rs 30 crore.

The bank's net position:

Premiums paid over 3 years = 90,00,000 × 3 = Rs  2,70,00,000
Payout received                            = Rs 30,00,00,000
Net benefit                                = Rs 27,30,00,000

Without the CDS the bank would have written down Rs 30 crore. With it, its loss was Rs 2.7 crore of premium — the cost of the protection.

Now the other side. Suppose instead the issuer survives all five years. The bank pays Rs 4.5 crore over the life of the contract and receives nothing, and the protection seller books Rs 4.5 crore of income for taking a risk that never materialised. That is the trade, and the seller is the one who has to be right about the probability.

Scale is the point of the BIS figures. Credit derivatives, CDS included, stood at USD 10,122 billion of notional outstanding in June 2023 — large, but less than a tenth of the USD 120,250 billion of foreign exchange contracts, and under 2% of the USD 714,744 billion total.

Chapter 2 (Foreign Exchange Derivatives), section 2.3, sets out the four generic derivative types and the grid of underlyings, then adds credit risk as an underlying with the CDS definition. Section 2.4 gives the BIS notional outstanding table in which credit derivatives appear as a line.

The question that comes from this is definitional and it is testable in one line: who pays whom, and when. The protection buyer pays a regular periodic payment; the protection seller pays the loss in value on the reference obligation if a credit event occurs. Questions also ask you to place CDS among the four generic types (it sits with swaps, and it is an OTC product) and, from section 2.4, to rank the OTC market by size — interest rate contracts far ahead of foreign exchange, with credit derivatives well behind both.

• The buyer of protection pays; the seller of protection receives — until a credit event, when the flow reverses. Getting the direction backwards is the only real trap in the definition.
• It is a swap, not an option, even though it behaves like insurance. The workbook classifies it by the exchange of payment streams over a period.
• "Credit event" is broader than bankruptcy. The workbook gives default as an example — e.g. — not as the definition.
• You need not own the reference obligation to buy protection on it, which is what turns a hedging instrument into a speculative one and is central to the 2008 story the workbook tells in section 2.6.
• CDS is OTC. It carries counterparty credit risk and settlement risk, which is precisely what exchange traded derivatives eliminate through the clearing corporation's trade guarantee.
• Do not confuse the abbreviation. In Series I, "CDS" also stands for the Currency Derivatives Segment of a stock exchange — and that is the meaning nine times out of ten in this paper.