Credit default swaps and their applications
Basic structure of a credit default swap (CDS)
In its simplest form, a CDS is a contingent payment that the protection seller (the party who provides the protection), makes to his CDS counterparty, the protection buyer (the party interested in acquiring credit protection), at the occurrence of a specified credit default event, relating to an underlying asset (the reference asset), commonly a loan, bond or receivable. The buyer of protection pays periodic fees to the seller, usually expressed as a percentage of the asset’s face value calculated in basis points (100ths of a percent).
The main objective of a CDS transaction is to provide the protection buyer with a credit “insurance” against risks of default on a reference asset.
Of crucial importance, is the definition of the credit default event that triggers the seller’s obligation. If the defined credit event occurs, the CDS transaction can be by physical settlement, where the protection seller is required to purchase the defaulted asset at its current value. Alternatively, settlement can be cash based. In these circumstances, the transaction is terminated by paying the difference between the original price of the asset and its current value determined after the occurrence of the credit event.
Applications and risks of credit default swaps
Credit default swaps allow users to identify and manage the credit risk on reference assets. They do this by replicating synthetically, the reference asset and isolating its elements. The risks underlying the different elements of the asset are considered and traded separately. The result is a minimization of the overall credit risk on the reference asset.
CDSs can be used by organisations as an effective coverage against the risk of default of their counterparties in specific transactions. CDSs, in fact, offer protection that is competitive compared to more traditional techniques of coverage against credit risks through say, credit insurance.
In addition to a general reduction of costs, the synthetic transfer of risks achieved by CDSs is achieved relatively simply. This is important when the reference asset is a loan included in a bank’s portfolio. Using a CDS, the bank can replicate synthetically the asset (i.e. without any physical transfer of property) isolating and transferring only the credit risk without transferring the underlying asset. In other words, the asset remains “physically” on the bank’s balance sheet even though the related credit risk is transferred to the CDS’s counterparty.
CDSs can also provide tax and accounting benefits. Purchasing default protection via a CDS, can hedge the credit risk without triggering adverse tax or accounting consequences present in a contract of sale. More often, the secondary market for many loans and private placements might not exist at all. In addition, the loan agreement can sometimes prohibit the sale of the loan to third parties.
Credit default swaps can also be employed effectively by investors within a more complex investment strategy. Assuming that an investor owns a high credit-risky asset able to generate high income but requiring considerable funding costs, credit default swaps offer an opportunity to acquire default protection offsetting the credit risk while retaining the asset which generates the income. CDSs, therefore, are becoming an important source of investment opportunities and portfolio diversification for banks, insurance companies and other institutional investors.
However, CDSs usage is not entirely risk-free. In fact, an “overly adventurous” use of these instruments can involve more risks than advantages. Firstly, it is important to choose the protection seller with the right qualities. A good CDS counterparty is, of course, a high-rated entity not exposed to any risk of default. Another important consideration is the link between the protection seller and the reference asset. It is possibly more important to choose a protection seller that is unrelated to the asset even when their credit rating is comparatively lower. Finally, before entering into a credit default swap, the protection buyer should evaluate the possibility of adverse changes in the value of the reference asset other than those caused by the credit event. This kind of loss, is not covered by the CDS and is normally retained by the protection buyer. If the reference entity is easily exposed to price fluctuations, then other types of coverage are required in addition to a CDS (for example, by using interest rate swaps or currency swaps).