credit default swap

credit default swap
Name	Credit Default Swap
Type	Over-the-counter derivative
Underlying	Credit risk
Inventor	Blythe Masters
Market	Global financial system

credit default swap. A credit default swap is a financial derivative contract that allows one party to transfer the credit risk of a reference entity to another party. It functions as a form of insurance against the default of a corporate bond, sovereign debt, or other credit obligation. The buyer makes periodic payments to the seller and receives a payoff if the specified credit event occurs. These instruments became central to the Global financial crisis of 2007–2008 and are traded primarily in the over-the-counter market.

Definition and basic mechanics

In its fundamental form, the contract involves two counterparties: the protection buyer and the protection seller. The buyer pays a recurring fee, known as the credit spread, to the seller over the life of the contract. This fee is typically quoted in basis points per annum on the contract's notional amount. A credit event, as defined by the International Swaps and Derivatives Association master agreement, triggers the settlement process. Such events can include bankruptcy, failure to pay, or debt restructuring of the reference entity. Settlement can be physical, where the buyer delivers defaulted bonds to the seller for par value, or cash-based, determined via an auction process administered by entities like Markit Group.

Parties and structure

The primary participants are institutional actors such as commercial banks, investment banks, hedge funds, and insurance companies. A bank like JPMorgan Chase might buy protection to hedge its loan exposure to a corporation, while a fund like Bridgewater Associates might sell protection to earn premium income. The contract references a specific entity, which can be a corporation like General Motors or a sovereign nation like Greece. The terms are documented under the standardized ISDA Master Agreement, which provides legal definitions for credit events and settlement terms. Major facilitators include dealers like Goldman Sachs and Morgan Stanley, who make markets in these instruments.

Uses and applications

Financial institutions employ these contracts primarily for risk management, to hedge portfolios of corporate loans or bonds against potential losses. Speculators use them to take leveraged views on the creditworthiness of entities without owning the underlying debt security. For example, during the European debt crisis, many funds speculated against the debt of nations like Portugal and Italy. They also enable regulatory capital arbitrage, allowing banks to reduce capital requirements under frameworks like the Basel Accords. Furthermore, the CDS index, such as those managed by IHS Markit like the CDX and iTraxx series, allows for broad exposure to credit markets.

Pricing and valuation

The premium, or credit spread, is influenced by the probability of default and the loss given default of the reference entity. Models often draw from the Merton model of corporate debt, treating equity as a call option. In practice, pricing is heavily driven by the credit rating assigned by agencies like Standard & Poor's or Moody's Investors Service, and by the observable bond yield spread in the cash market. The LIBOR curve is typically used as the risk-free benchmark for discounting. Post-crisis, the Big Bang Protocol implemented by ISDA standardized many valuation and settlement conventions to improve market functioning.

Risks and criticisms

A major risk is counterparty risk, where the protection seller, such as American International Group during the 2008 crisis, may fail to pay following a credit event. This creates systemic risk through interconnected obligations, a key factor in the collapse of Lehman Brothers. The naked CDS, where the buyer has no insurable interest, has been criticized for potentially enabling market manipulation and excessive speculation, leading to bans in jurisdictions like the European Union. Furthermore, the complexity and opacity of the OTC market can obscure true levels of risk concentration, as seen in the subprime mortgage crisis.

Regulatory environment

In response to the financial crisis, major reforms were enacted, notably the Dodd–Frank Wall Street Reform and Consumer Protection Act in the United States. This legislation mandated central clearing for standardized contracts through central counterparties like ICE Clear Credit to mitigate counterparty risk. Reporting requirements to trade repositories such as the Depository Trust & Clearing Corporation were also imposed to increase transparency. Globally, the G20 nations agreed to similar reforms, with the European Market Infrastructure Regulation implementing clearing and reporting mandates across the European Union. Regulatory bodies like the Commodity Futures Trading Commission and the Securities and Exchange Commission oversee different aspects of the market.

Category:Derivatives (finance) Category:Financial risk