CDS: CREDIT DEFAULT SWAPS

CDS is a credit derivative contract between two counterparties.

It covers the following points:

1. Periodic payments made by buyer to the seller
2. Buyer receives a payoff if the associated credit instrument fails or on the occurrence of a specified event.
3. If no default occurs then premium paid until the end of the contract.

CDS VS INSURANCE
In Insurance and CDS both, the buyer pays periodic payment and receives a specified sum if the event occurs.

Points of difference between insurance and CDS

1. In case of CDS the buyer may or may not own the underlying security.
2. Buyer does not have to suffer a loss from the default in case of a CDS.

 
ROLE OF PROTECTION BANK IN CASE OF DEFAULT

Physical settlement:
Protection seller pays the buyer par value, takes delivery of a debt obligation of the reference entity .

Cash settlement:
Seller pays the buyer the difference between par value and the market price of the debt obligation.

USES OF - CDS
Can be used as Speculation, Arbitrage and Hedging tool.

Speculation

• Allows investor to speculate on changes in an entity’s credit quality.
• Credit-worthiness increases-CDS spread decreases n vice-versa.
• An investor may buy or sell the protection

Hedging
• CDS often used to manage the Credit-risk.

Arbitrage
• Company’s stock price and its CDS spread should exhibit a –ve correlation.
• Arbitrageur will try to exploit the market inefficiencies.

Auctions

• When a credit event occurs on a major company on which a lot of CDS contracts are written,an auction may be held to facilitate settlement of a large number of contracts at once,at a fixed cash settlement price.

• ISDA- auctions ,an effective way of settling large volumes of outstanding CDS contracts.

WHAT IF COUNTER PARTIES DEFAULT ?

• Risk of counter parties defaulting.
• Deregulation in CDS contracts not being public –Aggregated risk.
• Sudden loss and decrease in lending liquidity in 2008.
• After Lehman bankruptcy, companies reported to get more bankrupt.
• Since CDS spread was increasing , Lehman and AIG lost credit worthiness

SYSTEMIC RISK IN CREDIT DEFAULT SWAP

What is Systemic Risk?
 Risk of collapse of an entire system or entire market.
 Risks imposed by inter-linkages and interdependencies in a system or market
 which could bring down the entire system if one player is eliminated

CDS: SYSTEM RISK EXAMPLE
Company B buy a CDS from company A with a certain annual "premium", say 2%.

1. If the condition of the reference company worsens, the risk premium will rise
2. So company B can sell a CDS to company C with a premium of say, 5%, and pocket the 3% difference.
3. If the reference company defaults, company B might not have the assets on hand to payoff to C
4. It depends on its contract with company A to provide a large payout, which it then passes along to company C.

DIAGRAM 2

1. The problem lies if one of the companies in the chain fails, creating a “Domino effect" of losses.
2. I.e., If company A fails, Company B will default on its CDS contract to company C, possibly resulting in bankruptcy
3. Company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company.
4. Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A.

CONCLUSION

1. 
   
   The risk of counterparties defaulting has been amplified during the 2008 financial crisis,
2. Lehman Brothers and AIG were counterparties in a very large number of CDS transactions.
3. A contributing factor to the massive decrease in lending liquidity during September/October 2008
4. Defaults of Lehman Brothers and AIG, their inability to pay out on CDS contracts could lead to Systemic Risk
5. As an example, Imagine a mutual fund bought some Washington Mutual corporate bonds in 2005 and decided to hedge their exposure by buying CDS protection, from Lehman Brothers.

6. Lehman's goes BANKRUPT, and protection was no longer active.
7. Washington Mutual's sudden default only days later would have led to a massive loss on the bonds; a loss that should have been nullified by the CDS.

AFFECT ON AIG

1. CDS also played an integral role in the federal government's decision to bail out the American International Group,
2. One of the world's largest insurers, in September 2008.
3. A.I.G. failed and defaulted on its swaps.
4. The result could be a daisy chain of failures across the international financial system, thus Federal Government bail out AIG.