In just over a decade, the credit default swap (CDS) emerged on the scene, grew exponentially, found fame and fortune, and then crashed to the depths of public opinion — to the point that it is today blamed for the current financial crisis. The tarnished CDS is even accused as “the monster that ate Wall Street”. It was created to cover asset losses if a default happened, similar to taking out home insurance to protect against losses from fire and theft. Except that it did not. The CDS was traded from investor to investor with no oversight, ensuring that the “insurer” had the ability to cover the losses if the asset defaulted.
However, recently, the Malaysian Rating Corp Bhd indicated that CDS should be introduced in the local financial market to spur bond trading. With the CDS being in an infant stage in Malaysia, this could be a sound move, as we may be able to avoid the pitfalls encountered by the early adopters and trade it as an enhanced and rehabilitated product. In doing so, we would first need to understand the objective of the CDS and how it works. This article will try to explain just that.
How the CDS came aboutHow do you mitigate risk when you loan money to someone? That’s the age-old bankers’ dilemma. By the mid-1990s, JP Morgan was burdened with tens of billions of dollars of debt and by law, huge amounts of capital in reserve were needed in case any of the debt went bad. Bankers wanted something that would protect them if those loans defaulted and at the same time, free up that precious capital. It was like an insurance policy, where a third party will assume the risk of the loan going bad, in exchange for regular payments from the bank, resembling insurance premiums. The instrument was called the credit default swap. Essential featuresA CDS is a contract between two parties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection and is called the “protection buyer”. The second party gives credit protection and is called the “protection seller”. The third party, the one that may go bankrupt or default, is known as the “reference asset”. To illustrate, A and B enter into a CDS contract where the reference asset is a Ford Motor plain vanilla bond with a notional of 100. The tenor of the CDS is five years. A is the protection buyer and he will pay a fixed premium (for example, 2% of 100) at regular intervals (for example, annually) to the protection seller, B. B in return will compensate A in case the bond defaults anytime in the five-year term. Say, at Year Three, the bond fails to meet the annual coupon payments. If this qualifies as a default event in the contract, then B will have to compensate A for his losses. Now for A, his loss is really the principal amount invested in the bond (for example, 100) minus what he can recover from the bond upon liquidation (for example, 60). So A receives a payoff of 40 from B.
The price of a CDS is quoted by its premium. How much of a premium A pays B is largely connected to the default probability of the Ford bond. The higher the probability of default, the more premium is demanded by B as his chances of making the default payout is higher. Determining the default probability of the reference asset is a fascinating subject and can take a whole new chapter. Hence it is best to leave it for a separate topic at a later stage.
Note that A may or may not own the Ford bond. If A owns the bond, with the CDS in place, A’s position is flat (hedged) and B synthetically owns the bond (long the bond). The latter case is called a naked CDS where both A and B are synthetically short and long the bond.
The CDS is traded as an over-the-counter (OTC) product. As such, various features in the CDS are custom-made according to the parties’ preferences, causing it to be a non-standard product in the market. The main non-standard features are as follows:
The default event or credit event, which can take many forms: bankruptcy, failure to pay, repudiation/ moratorium and restructuring to name a few. The CDS parties may choose to include all or some of the credit events in their contract. The restructuring clause is used differently in the US and Europe and can cover a wide or limited range of restructuring events. Thus there could be several versions of a Ford CDS in the market, each having different definitions of restructuring clauses as the credit event, with different premium quotations.
The recovery value of the bond (60 in the above example), which is determined by auction. The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default. The International Swaps and Derivatives Association (ISDA) calculates an average recovery value for the underlying bonds from various submissions by market makers.
Settlement, usually in cash, where the seller pays the buyer the difference between the principal and the recovery value of the bond. However, physical settlement can also be stipulated in the contract. Here, upon trigger of a credit event, the buyer delivers the bond to the seller, and the seller pays the principal value of the bond. Premium quotations for reference assets (or credit names) are done in a non-orderly fashion. Dealers quote them through emails. A financial information services company called “Mark It” provides a service only for interested market participants by pooling their quotes and providing an average price. This enables the participants to have an idea of how far or close their prices are compared to the market, especially for the less liquid names.The emerging ‘monster’CDSs were meant for businesses to shift credit risk to other firms, chiefly financial institutions (banks, insurance companies, fund houses, and so on) that are willing to bear them. A commercial bank concerned about its credit exposure to an airline company can just transfer some of its default risk to other banks via a CDS without actually selling the underlying loans.
Within a few years, the CDS became the hot financial instrument, the “perfect” way to trade credit risk, by transferring it to investors with the appetite to take on this risk for a steady return.
But the humble CDS was then turned into a “monster” it was never meant to be. Disastrous events followed. Giant firms that were “too big to fail” were brought down to their knees.
Source : This article appeared on the Corporate page of The Edge Malaysia, Issue 788, Jan 11-17, 2010.
To open an account and start investing, visit Zerodha
However, recently, the Malaysian Rating Corp Bhd indicated that CDS should be introduced in the local financial market to spur bond trading. With the CDS being in an infant stage in Malaysia, this could be a sound move, as we may be able to avoid the pitfalls encountered by the early adopters and trade it as an enhanced and rehabilitated product. In doing so, we would first need to understand the objective of the CDS and how it works. This article will try to explain just that.
How the CDS came aboutHow do you mitigate risk when you loan money to someone? That’s the age-old bankers’ dilemma. By the mid-1990s, JP Morgan was burdened with tens of billions of dollars of debt and by law, huge amounts of capital in reserve were needed in case any of the debt went bad. Bankers wanted something that would protect them if those loans defaulted and at the same time, free up that precious capital. It was like an insurance policy, where a third party will assume the risk of the loan going bad, in exchange for regular payments from the bank, resembling insurance premiums. The instrument was called the credit default swap. Essential featuresA CDS is a contract between two parties, in which one makes periodic payments to the other and gets promise of a payoff if a third party defaults. The first party gets credit protection and is called the “protection buyer”. The second party gives credit protection and is called the “protection seller”. The third party, the one that may go bankrupt or default, is known as the “reference asset”. To illustrate, A and B enter into a CDS contract where the reference asset is a Ford Motor plain vanilla bond with a notional of 100. The tenor of the CDS is five years. A is the protection buyer and he will pay a fixed premium (for example, 2% of 100) at regular intervals (for example, annually) to the protection seller, B. B in return will compensate A in case the bond defaults anytime in the five-year term. Say, at Year Three, the bond fails to meet the annual coupon payments. If this qualifies as a default event in the contract, then B will have to compensate A for his losses. Now for A, his loss is really the principal amount invested in the bond (for example, 100) minus what he can recover from the bond upon liquidation (for example, 60). So A receives a payoff of 40 from B.
The price of a CDS is quoted by its premium. How much of a premium A pays B is largely connected to the default probability of the Ford bond. The higher the probability of default, the more premium is demanded by B as his chances of making the default payout is higher. Determining the default probability of the reference asset is a fascinating subject and can take a whole new chapter. Hence it is best to leave it for a separate topic at a later stage.
Note that A may or may not own the Ford bond. If A owns the bond, with the CDS in place, A’s position is flat (hedged) and B synthetically owns the bond (long the bond). The latter case is called a naked CDS where both A and B are synthetically short and long the bond.
The CDS is traded as an over-the-counter (OTC) product. As such, various features in the CDS are custom-made according to the parties’ preferences, causing it to be a non-standard product in the market. The main non-standard features are as follows:
The default event or credit event, which can take many forms: bankruptcy, failure to pay, repudiation/ moratorium and restructuring to name a few. The CDS parties may choose to include all or some of the credit events in their contract. The restructuring clause is used differently in the US and Europe and can cover a wide or limited range of restructuring events. Thus there could be several versions of a Ford CDS in the market, each having different definitions of restructuring clauses as the credit event, with different premium quotations.
The recovery value of the bond (60 in the above example), which is determined by auction. The auction system was put in place seven years ago to centralise agreement of the recovery rate on company bonds in default. The International Swaps and Derivatives Association (ISDA) calculates an average recovery value for the underlying bonds from various submissions by market makers.
Settlement, usually in cash, where the seller pays the buyer the difference between the principal and the recovery value of the bond. However, physical settlement can also be stipulated in the contract. Here, upon trigger of a credit event, the buyer delivers the bond to the seller, and the seller pays the principal value of the bond. Premium quotations for reference assets (or credit names) are done in a non-orderly fashion. Dealers quote them through emails. A financial information services company called “Mark It” provides a service only for interested market participants by pooling their quotes and providing an average price. This enables the participants to have an idea of how far or close their prices are compared to the market, especially for the less liquid names.The emerging ‘monster’CDSs were meant for businesses to shift credit risk to other firms, chiefly financial institutions (banks, insurance companies, fund houses, and so on) that are willing to bear them. A commercial bank concerned about its credit exposure to an airline company can just transfer some of its default risk to other banks via a CDS without actually selling the underlying loans.
Within a few years, the CDS became the hot financial instrument, the “perfect” way to trade credit risk, by transferring it to investors with the appetite to take on this risk for a steady return.
But the humble CDS was then turned into a “monster” it was never meant to be. Disastrous events followed. Giant firms that were “too big to fail” were brought down to their knees.
Source : This article appeared on the Corporate page of The Edge Malaysia, Issue 788, Jan 11-17, 2010.
To open an account and start investing, visit Zerodha