Swap essentially is a contract between two parties (usually called ‘counter parties’) to exchange with each other cash flows spread across a period of time depending upon the terms of the swap contract.
Any swap contract involves counter parties with exactly opposite financial views about the market, stock price, interest rates etc.
Credit default swaps also involve counter parties with opposite views about the credit risks involved in holding the debt of any Corporation or any Sovereign debt security.
Risky corporate & sovereign bonds are the most recent type of securities that have benefited from the related derivative contracts. There is always inherent risk of default is involved in any bond or debt security. The default by the issuer of the bond or other debt is termed as a credit event.
Credit Default Swaps (CDS) are used as a medium to transfer credit risk from one investor who wishes to avoid credit risk (the protection seeker) to another investor who is willing to assume the risk (the protection seller).
A CDS contract is meant to provide protection to holder of Corporate or Government bonds or other debt from the credit risk involved in holding these securities in case of a credit event.
In a typical CDS contract the holder of the bond or debt buys the protection from the protection seller against the credit risk arising out of a credit event. Here the protection seller agrees to buy the bonds or debt security (reference obligation) at par value in case of a credit event happening.
In return for the protection provided the protection buyer makes periodical payments (CDS Spread) to the protection seller till the time the credit event occurs or the maturity of the reference obligation which ever is earlier. These periodical payments are usually calculated by applying pre agreed basis points on the Notional Principal involved.
Sometimes the CDS contract may provide for cash settlement between the protection buyer & the protection seller in case of a credit event happening.
Important Terms in CDS Contract:
1) Reference Entity:
The Company or Government issuing the Bonds or debt in question is called as reference entity.
2) Credit Event:
Any default in payment of any servicing or maturing of bond by the reference entity is called as the Credit Event.
3) Reference Obligation:
The Bond or debt for which the buyer of CDS is buying a protection against a credit risk is called as a reference obligation.
4) Notional Principal :
The notional principal is the total par value of the reference obligation. Suppose for example if the Par value of Bond X is $100 & the protection buyer is holding 100,000 units of Bond X then the Notional Principal of the CDS would be $10,000,000 i.e. (100 x 100,000)
5) Spread:
The periodical payment made by the protection buyer to the protection seller is called as CDS spread. Customarily, if the tenure of two different bonds is same but their CDS spreads are not same it can be said that the bond having higher spread is more risky & the probability of the default is more for it.
A CDS contract is similar to insurance contract in the sense that both the contracts involve buying a protection against some inherent risk. However, in CDS contracts it is not necessary that the buyer of the protection should have ownership interest in the underlying asset. The contract of insurance essentially requires that the insured person (the protection buyer) should have insurable interest in the asset being insured.
This feature of a CDS has facilitated speculation as it is not necessary that you should be holding the bond to buy a CDS for that bond. Moreover, in case of a credit event happening for that bond it is not even necessary that the CDS buyer should have incurred a loss due to the credit event happening. This kind of CDS trading is called as Naked CDS & many people think & rightly so that these should be banned as it encourages rigorous speculation without any beneficial bonafide interest in the underlying security.
Settlement of the CDS contract:
It is necessary that there should a credit event to initiate the process of settling the CDS.
The CDS contract can be settled by either Physical delivery or by Cash Settlement.
• Physical Settlement:
In physical settlement of a CDS the buyer of protection would deliver the reference obligation (bonds/debt) to the protection seller & the Protection seller would pay the Notional Principal (the par value of the holding) to the protection buyer.
• Cash Settlement:
In Cash Settlement of the CDS the protection buyer is paid the amount equal to the difference between Par value & the market price of the reference obligation after the credit event happens. The market price is determined by polling the dealers in the market.
Example of a Credit Default Swap
Suppose two parties enter into a five year CDS contract for Bond X on August 2010. The protection buyer agrees to pay 75 basis points annually in return for the protection in the event of the credit event happening. The total par value of the underlying bond (reference obligation) is say $10 million. The protection buyer would pay $75,000 annually to the protection seller. There is no credit event till Dec 2013. In this scenario the buyer of protection would have paid 4 annual payments till August 2013. As per the standard practice in the market the protection buyer also need to pay the amount of annual payment accrued for the period Sept. 2013 to Dec 2013.
In case of physical settlement the protection buyer would sell $ 10 million bonds to the protection seller & would receive $ 10 million.
In case of cash settlement suppose the post credit event market valuation of the reference obligation (bond/debt instrument) is determined to be $ 40 per unit for a par value of $100 the protection buyer would receive the balance amount i.e. $6 million from the protection seller.
OTC Nature of CDS Market
The CDS trading is currently done over the counter (OTC) of Investment Bankers. As per an estimate by Depository Trust & Clearing Corporation (DTCC) the notional amount of the total CDS outstanding as of April 2009 was about $28 trillion. The OTC nature essentially carries counterparty risk in CDS. The protection buyer may default in paying the CDS spread to the protection seller or the protection seller may default paying the protection buyer in case of a credit event happening for the reference entity. This type of risk is called as ‘Counter party Risk’. The counter party risk is highly dependent upon the overall economic conditions prevailing in an economy. The chain reaction of counter party defaults may expose the whole economy to systematic risk.
As per experts, given the huge volume of CDS trade worldwide it is necessary to regulate the CDS market & they recommend of clearing the CDS trades through central clearing houses. This indeed would result in eliminating the counter party risk involved in CDS trade.
I hope this article would help you to gain a basic understanding of the Credit Default Swaps. In my next article we would discuss the valuation & accounting treatment of CDS. Till then enjoy the reading!
Any swap contract involves counter parties with exactly opposite financial views about the market, stock price, interest rates etc.
Credit default swaps also involve counter parties with opposite views about the credit risks involved in holding the debt of any Corporation or any Sovereign debt security.
Risky corporate & sovereign bonds are the most recent type of securities that have benefited from the related derivative contracts. There is always inherent risk of default is involved in any bond or debt security. The default by the issuer of the bond or other debt is termed as a credit event.
Credit Default Swaps (CDS) are used as a medium to transfer credit risk from one investor who wishes to avoid credit risk (the protection seeker) to another investor who is willing to assume the risk (the protection seller).
A CDS contract is meant to provide protection to holder of Corporate or Government bonds or other debt from the credit risk involved in holding these securities in case of a credit event.
In a typical CDS contract the holder of the bond or debt buys the protection from the protection seller against the credit risk arising out of a credit event. Here the protection seller agrees to buy the bonds or debt security (reference obligation) at par value in case of a credit event happening.
In return for the protection provided the protection buyer makes periodical payments (CDS Spread) to the protection seller till the time the credit event occurs or the maturity of the reference obligation which ever is earlier. These periodical payments are usually calculated by applying pre agreed basis points on the Notional Principal involved.
Sometimes the CDS contract may provide for cash settlement between the protection buyer & the protection seller in case of a credit event happening.
Important Terms in CDS Contract:
1) Reference Entity:
The Company or Government issuing the Bonds or debt in question is called as reference entity.
2) Credit Event:
Any default in payment of any servicing or maturing of bond by the reference entity is called as the Credit Event.
3) Reference Obligation:
The Bond or debt for which the buyer of CDS is buying a protection against a credit risk is called as a reference obligation.
4) Notional Principal :
The notional principal is the total par value of the reference obligation. Suppose for example if the Par value of Bond X is $100 & the protection buyer is holding 100,000 units of Bond X then the Notional Principal of the CDS would be $10,000,000 i.e. (100 x 100,000)
5) Spread:
The periodical payment made by the protection buyer to the protection seller is called as CDS spread. Customarily, if the tenure of two different bonds is same but their CDS spreads are not same it can be said that the bond having higher spread is more risky & the probability of the default is more for it.
A CDS contract is similar to insurance contract in the sense that both the contracts involve buying a protection against some inherent risk. However, in CDS contracts it is not necessary that the buyer of the protection should have ownership interest in the underlying asset. The contract of insurance essentially requires that the insured person (the protection buyer) should have insurable interest in the asset being insured.
This feature of a CDS has facilitated speculation as it is not necessary that you should be holding the bond to buy a CDS for that bond. Moreover, in case of a credit event happening for that bond it is not even necessary that the CDS buyer should have incurred a loss due to the credit event happening. This kind of CDS trading is called as Naked CDS & many people think & rightly so that these should be banned as it encourages rigorous speculation without any beneficial bonafide interest in the underlying security.
Settlement of the CDS contract:
It is necessary that there should a credit event to initiate the process of settling the CDS.
The CDS contract can be settled by either Physical delivery or by Cash Settlement.
• Physical Settlement:
In physical settlement of a CDS the buyer of protection would deliver the reference obligation (bonds/debt) to the protection seller & the Protection seller would pay the Notional Principal (the par value of the holding) to the protection buyer.
• Cash Settlement:
In Cash Settlement of the CDS the protection buyer is paid the amount equal to the difference between Par value & the market price of the reference obligation after the credit event happens. The market price is determined by polling the dealers in the market.
Example of a Credit Default Swap
Suppose two parties enter into a five year CDS contract for Bond X on August 2010. The protection buyer agrees to pay 75 basis points annually in return for the protection in the event of the credit event happening. The total par value of the underlying bond (reference obligation) is say $10 million. The protection buyer would pay $75,000 annually to the protection seller. There is no credit event till Dec 2013. In this scenario the buyer of protection would have paid 4 annual payments till August 2013. As per the standard practice in the market the protection buyer also need to pay the amount of annual payment accrued for the period Sept. 2013 to Dec 2013.
In case of physical settlement the protection buyer would sell $ 10 million bonds to the protection seller & would receive $ 10 million.
In case of cash settlement suppose the post credit event market valuation of the reference obligation (bond/debt instrument) is determined to be $ 40 per unit for a par value of $100 the protection buyer would receive the balance amount i.e. $6 million from the protection seller.
OTC Nature of CDS Market
The CDS trading is currently done over the counter (OTC) of Investment Bankers. As per an estimate by Depository Trust & Clearing Corporation (DTCC) the notional amount of the total CDS outstanding as of April 2009 was about $28 trillion. The OTC nature essentially carries counterparty risk in CDS. The protection buyer may default in paying the CDS spread to the protection seller or the protection seller may default paying the protection buyer in case of a credit event happening for the reference entity. This type of risk is called as ‘Counter party Risk’. The counter party risk is highly dependent upon the overall economic conditions prevailing in an economy. The chain reaction of counter party defaults may expose the whole economy to systematic risk.
As per experts, given the huge volume of CDS trade worldwide it is necessary to regulate the CDS market & they recommend of clearing the CDS trades through central clearing houses. This indeed would result in eliminating the counter party risk involved in CDS trade.
I hope this article would help you to gain a basic understanding of the Credit Default Swaps. In my next article we would discuss the valuation & accounting treatment of CDS. Till then enjoy the reading!
No comments:
Post a Comment