Credit Default Swaps (CDS)

Derivatives_Novice_Notes_Week23: Credit Default Swaps (CDS)

Credit Default Swap (CDS) contracts are typically negotiated directly between buyers and sellers in the OTC market. The OTC market offers greater flexibility regarding contract customization, allowing participants to tailor contracts based on specific needs and preferences. This flexibility is one of the main reasons for the popularity of CDS instruments.

A CDS contract allows one party to transfer the credit risk of a borrower to another party. These swaps work like an insurance policy and offer protection against the default of a debt instrument such as a corporate bond or sovereign debt. The buyer of a CDS pays regular Premiums (known as the CDS Spread) to the seller in exchange for protection against the risk of a default on the referenced debt. In case of default, the seller reimburses the buyer typically by paying the notional value of the debt or a portion of it, depending on the terms of the contract.

How Does a CDS Work?

• The protection buyer pays regular premiums (similar to an insurance policy) to the protection seller.
• Suppose a credit event occurs (e.g., the reference entity defaults). In that case, the protection seller must compensate the protection buyer, typically by paying the face value of the debt (minus any recovery value from the defaulted entity’s assets). The ownership transfers to the seller.
• In case of NO credit default throughout the life of a CDS contract, the buyer of the credit default swap must make the premium payments to the seller. The payments continue until the CDS reaches maturity. The contract expires worthless.

Key Elements of a CDS Contract

• Reference Entity: The entity whose credit risk is being traded. In most CDS contracts, this is typically the issuer of the underlying debt (such as a corporation, government, or sovereign entity).
• Notional Amount: The amount of exposure to the reference entity's credit risk that the buyer is seeking protection against, which also serves as the basis for the premium payments. It is the size of the position that is being protected.
• CDS Spread (Premium): The annual fee the CDS buyer pays to the seller, typically quoted in basis points (bps) of the notional amount. This premium reflects the perceived credit risk of the reference entity.
• Protection Buyer: The party who purchases credit protection against the risk of default by the reference entity. The buyer pays periodic premiums (the CDS spread) to the seller in exchange for protection. Example: If hedge funds like Citadel or asset managers like PIMCO buy protection on Ford Motor company bonds, Citadel and PIMCO are the protection buyers.
• Protection Seller: The Protection Seller is the party that agrees to provide credit protection to the buyer in exchange for periodic premium payments. The seller assumes the credit risk of the reference entity and must pay out if a credit event occurs. Example: In the case of Deutsche Bank and Barclays selling protection, they are the protection sellers.
• Credit Event: An event that triggers the payment from the protection seller to the protection buyer such as default, bankruptcy, failure to pay, or restructuring of the reference entity’s debt.
• Settlement Mechanism: The method used to resolve a credit event, how the protection seller will compensate the protection buyer when a credit event occurs. There are two common settlement methods:

Physical Settlement: The protection buyer delivers defaulted bonds to the protection seller in exchange for the notional amount (or a portion of it).

Cash Settlement: The protection seller pays the protection buyer the difference between the notional amount and the market value of the defaulted bonds.

• Recovery Rate: The percentage of the notional value that can be recovered from the defaulted reference entity’s debt (usually determined by market auction or other methods after a credit event). This determines how much the protection buyer will receive in the event of a credit event. Example: If Ford Motor Company Bond CDS contracts, Ford defaults, and the recovery rate is 40%, the protection buyer will receive 60% of the notional amount as compensation.
• Payment Frequency: the Frequency when the protection buyer pays the premium payments to the protection seller (e.g., quarterly, annually).
• Maturity (Term): The Maturity (or Term) refers to the length of time the CDS contract is in effect. The typical duration is usually between 1 and 10 years. Example: A 5-year CDS contract on Ford bonds would have a maturity of 5 years, during which time the protection buyer will make premium payments and the protection seller will remain liable for covering any potential credit events.?

Pros and Cons of credit default swaps

• Pros: Credit default swaps can act as insurance against a damaging market event which causes borrowers to default on their debt obligations. As a result, lenders who buy a CDS are more protected against default than if they did not buy the CDS.
• Cons: Credit default swaps require the buyer to pay a quarterly premium to insure themselves. Because of this, the lender should assess whether their risk exposure is sufficient to justify buying the CDS in the first place. ?

In the event of an extremely harmful unanticipated market occurrence, like the 2008 financial crisis. If this occurs, credit default swap sellers could also be forced to default on their obligation to pay the buyer of the CDS, and the CDS buyer is left without protection and frequently forfeits the premium they paid for the CDS.

Understanding an End-to-End CDS Trade

A typical OTC Trade lifecycle for a CDS contract has the following phases.

Trade Execution (Initial Agreement)-> Trade Confirmation-> Trade Novation or Clearing (if CCP is used)->Premium Payments-> Monitoring -> Credit Event (when CDS is triggered) -> Credit Event Determination and Settlement -> Final Settlement

Let’s understand the entire process of a Credit Default Swap (CDS) trade for Nestlé S.A. (NSRGY), involving the parties: BlackRock (Seller), UBS (Buyer), J.P. Morgan (Broker), and CME Group’s CBOT (Central Counterparty or CCP). Assuming the trade is cleared through a CCP (CME Group's CBOT) for better risk management.

Contract Details:

• Reference Entity: Nestlé S.A. (NSRGY)
• Protection Seller: BlackRock
• Protection Buyer: UBS
• Broker: J.P. Morgan
• Central Counterparty (CCP): CBOT
• Notional Amount: $10 million
• CDS Premium (Spread): 2% per annum on the notional value, paid quarterly
• Tenure: 5 years
• Settlement Type: Cash settlement (assuming no physical delivery)

Trade Execution (Initial Agreement)

• Parties: The Buyer (UBS) wants protection against the credit risk of Nestlé S.A. (NSRGY), a global consumer goods company, which is the Reference Entity. The Seller (BlackRock) agrees to provide that protection.
• Role of Broker (J.P. Morgan): J.P. Morgan, acting as an intermediary, helps facilitate the negotiation of the terms of the CDS contract between UBS and BlackRock. The broker also helps in determining the CDS spread (the premium the buyer will pay) based on market conditions and credit risk assessment of Nestlé.

Key terms are negotiated:

• Notional Amount: $10 million (the size of the position being protected).
• Premium: 2% per annum on the notional amount, paid quarterly. This equates to $200,000 annually, or $50,000 quarterly.
• Credit Event: Default, bankruptcy, or failure to pay by Nestlé.
• Settlement Type: Cash settlement, meaning if a credit event occurs, the seller will pay the buyer the difference between the notional value and the recovery value of the Nestlé bonds.
• Tenure: 5 years

?Trade Confirmation

• Once terms are agreed upon, the trade is booked by both parties in their internal systems. J.P. Morgan helps confirm the agreed-upon terms in writing.
• Both BlackRock and UBS confirm the trade’s terms electronically through an industry-standard platform (e.g., Markit, DTCC, or DOCS) for documentation purposes.

Trade Novation (Clearing through CBOT)

?As the trade is cleared through a Central Counterparty (CCP), CBOT; the process of novation occurs. This means that CBOT becomes the counterparty to both BlackRock and UBS, effectively guaranteeing the trade and reducing the risk of default by either party.

• BlackRock (Protection Seller) now interacts with the CCP (CBOT) instead of UBS.
• UBS (Protection Buyer) now interacts with the CCP (CBOT) instead of BlackRock.
• Both BlackRock and UBS must post an initial margin with the CCP as collateral, which can fluctuate based on market conditions and the creditworthiness of the reference entity (Nestlé).
• The CCP also requires both parties to post a variation margin if the value of the trade changes during the life of the contract.

Ongoing Premium Payments

The protection buyer (UBS) begins making premium payments to the protection seller (BlackRock). This payment is typically structured on a quarterly basis and are paid directly to BlackRock (via the CCP).

Quarterly Premium = (CDS Spread * Notional Amount)/Premium Frequency annually ?

= (2% * 10,000,000)/4 = $50,000

UBS will pay $50,000 at the end of each quarter for the first year.

These payments will continue for the entire 5-year term of the contract (which equals 20 quarters, as there are 4 quarters per year), totaling:

Total Premium Payment (5yrs) = Quarterly Premium * No. of Quarters

= 50, 000 * 20 = $1,000,000

Monitoring and Risk Management

• ?CBOT, acting as the CCP, monitors the position to ensure adequate margin is maintained. If the market moves significantly, the CCP may call for variation margin adjustments, ensuring both parties maintain sufficient collateral to cover potential losses.

Credit Event Occurs (if applicable)

• If Nestlé S.A. experiences a credit event (such as default, bankruptcy, failure to pay, or a significant restructuring of its debt), the protection buyer, UBS, can trigger the CDS. A Credit Derivatives Determinations Committee (CDDC) would assess whether a credit event has occurred.
• In this case, assume a credit event is confirmed, and the cash settlement mechanism is triggered (assuming physical settlement is not used).

?Credit Event Settlement

Once the CDDC confirms a credit event, the cash settlement process includes:

• Determining the Recovery Rate: The recovery rate is calculated based on the market value of Nestlé's debt post-default. Suppose the recovery rate is determined to be 40%.
• Settlement Amount: The protection seller (now facing the CCP, CBOT) must pay the protection buyer (UBS) the difference between the notional value and the recovery rate.
• For a $10 million notional and 40% recovery rate:

Settlement Payment = Notional * (1-Recovery Rate)

???????? = 10, 000, 000 * (1- 0.40) = $6, 000, 000

Thus, BlackRock (through the CCP) will pay UBS $6 million.

Final Settlement

• Once the cash settlement is completed, the CDS contract is terminated, and all obligations are fulfilled.?
• Contract Expiry (No Credit Event): If there is no credit event during the term, the protection buyer (UBS) simply stops making premium payments once the 5-year tenure ends.
• At the end of the CDS contract, assuming no credit event, UBS would have paid a total of $1 million in premiums, and BlackRock would have received the premiums as compensation for taking on the credit risk.

As CDS offers a way to hedge credit risk and enable speculation on the creditworthiness of different businesses, Credit Default Swaps (CDS) are essential to OTC trading. While the OTC nature of CDS contracts offers flexibility, it also presents risks associated with market transparency and counterparty default. As the CDS market continues to evolve, it remains an essential tool for financial institutions, investors, and corporations looking to manage credit risk.

That is all on Credit Default Swaps. Thank You!

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