Sheet Instrument: Credit Default Swaps (CDS)

This article aims to present one of the main instruments of the category of credit derivatives, credit default swaps.

Description of credit default swaps

A Credit Default Swap, French swap default risk is part of the category of credit derivatives. It is an instrument of OTC recorded off-balance.
CDS allow the transfer of credit risk of a reference entity underlying contract (corporate risk, sovereign risk ...) between two parties in a synthetic way, that is to say without giving the reference asset.
A CDS allows the buyer (who is also a "seller" of risk) to guard against the occurrence of certain events (such as bankruptcy or default of the reference entity) may lead to losses in transferring the risk to the seller of CDS (which is also "buyer" risk). CDS are also often compared to insurance contracts, the seller of protection would be the insurer and the insured buyer protection. However, CDS differ from them in several important ways:
The buyer of a CDS does not need to have actually hedged assets
The buyer does not need to have actually suffered a loss to receive the contingent payment fixed in the contract. Thus, the CDS can be used not only as an instrument of protection, but can also be used for speculation pure and simple.
The risk covered by the contract is the underlying impairment following an incident on the quality of the issuer, called credit event (in English: credit event).
Guaranteed assets (the underlying) of this insurance can be either a particular asset (usually a bond), a transmitter (a signature).

Operation

The CDS is a bilateral financial contract in which the buyer (protection) agrees to pay a periodic fee - typically expressed in basis points of the notional amount of the transaction - and the seller (of protection) to keep ready to make a contingent payment to the default (or upon the occurrence of any event specified credit contract) of the reference entity.

Flow diagram of a Credit Default Swap
(CDS)

Financial flows

Initiation of contract

At the conclusion of the operation, no payments shall be made between the parties. The protection buyer to the protection seller transferred the credit risk of the reference entity and the contract, the duration of the latter, which is typically 5 years.

Life of the contract

The swap is divided into a fixed portion and a variable portion "conditional"
The fixed leg of the swap (n bp multiplied by the nominal amount of the transaction) shall be paid by the purchaser until the contract expires or, if necessary, until the occurrence of a credit event.
Example: a CDS on a nominal 15 million negotiated with a 50bp fee payment quarterly (Actual/360 basis) generate cash on a quarterly 92 days the sum of [15,000,000 x 0.5% x 92 / 360 =] 19 € 166.67.
The variable leg is activated upon the occurrence of a credit event in the life of the contract, which triggers protection.

Characteristics of a CDS

At the conclusion of the CDS, the contracting parties must agree on the following points:

The reference entity

This element defines the exact nature of the entity which both parties of the transaction transferring credit risk: the name of the entity or sovereign, as well as its name, where applicable.
A market convention addresses the question of the succession of the reference entity, if it ceases to exist due to a merger or demerger during the life of the contract.

Or the reference assets (the underlying)

Are defined by the type of debt or debt reference on which to found the occurrence or non-occurrence of the credit. Here are some examples:

Payment

• Any present or future payment of the reference entity.

Borrowed money

• The debt incurred by the reference entity.

Bonds or bank loans

• Bonds or bank loans contracted by the reference entity.

Bond debt

• Bond debt incurred by the reference entity.

Bank loans

• Bank loans contracted by the reference entity.

Reference Obligation

• A bond issued by the reference entity.

The nominal

• The nominal amount of the protection.

The deadline

• The maturity date of the contract.

Premium and frequency of payments

• The premium paid by the protection buyer to the seller, and the frequency with which payments must intervene.

Credit events covered

• Under this item are specified events that will trigger the contract. There are the following events:
• The bankruptcy of the reference entity
• The default on interest or principal amount of debt
• The debt restructuring. This event can take forms which are listed below, but their inclusion is subject to certain conditions, including a minimum size of debt affected by the restructuring that the restructuring is not expected at the time of the issue, the fact that the death occurred events resulting directly or indirectly from a deterioration in the financial condition of the Reference Entity:
• Reduction of the nominal
• Lengthening of maturities
• Change currency to a currency nonstandard
• Subordination (derating priority of payment in case of default) debt
• eg lengthening maturities, reducing the amount owed etc.
• Moratorium or debt repudiation

Cases reserved for sovereign reference entities. This particular case occurred in 1992 when Mexico declared a unilateral moratorium on its debt.

The contingent payment and settlement

Settlement of payment can be done in two ways:

• Physical settlement

This is the case most frequently used. The buyer of the CDS book seller of securities in default of the reference entity, and in return he receives from the seller the notional amount of the transaction.

• Regulations in "cash"

In this variant, the seller pays the buyer the difference between the residual value and the nominal title.