Credit Default Swap (CDS)

Financial Times  Jul 16  Comment 
Citi has recommended buying credit default swaps on UK government bonds, as a vote for independence could trigger a payout under the insurance contracts
The Economic Times  Jul 14  Comment 
Markit iTraxx Europe senior financial index of credit default swap has risen, the yield on 10-yr Portuguese bonds surged in three months.
SeekingAlpha  Jul 12  Comment 
By Donald van Deventer: A number of authors have suggested that credit default swap pricing be used as a basis for setting deposit insurance premiums for banking firms. We re-examine this proposal in this note, the sixth of a semiannual series of...
Mondo Visione  Jul 11  Comment 
The European Securities and Markets Authority (ESMA) has launched a first round of consultations to prepare for central clearing of OTC derivatives within the European Union. The two consultation papers seek stakeholders’ views on draft...
SeekingAlpha  Jul 10  Comment 
By Donald van Deventer: We previously analyzed the trading volume of credit default swaps on international bank reference names on February 11, 2014 for the 181 weeks ending December 27, 2013. This note updates that analysis for the 207 weeks...
SeekingAlpha  Jul 10  Comment 
By Donald van Deventer: The bankruptcy of Detroit brings new pressure on municipal bond investors and related exchange-traded funds like HYD, NUV, PML, PZA, IIM, NIO and VMO specializing in municipal bonds to heighten risk management and to hedge...  Jun 19  Comment 
NEW YORK (TheStreet) -- American Apparel's controversial founder Dov Charney was ousted as chairman on Wednesday, but the company's debt situation may provide more troubles ahead.Its June 18, SEC filing states that the suspension of Dov Charney...
The Economic Times  Jun 12  Comment 
Turkish stocks stayed near two-week lows after suffering their biggest one-day loss in more than five months but credit default swaps stabilised after rising 7 bps.


Credit default swaps, or CDS, are insurance against the risk of default on a debt (such as loan, bond etc.). The writer (seller) of these swaps receive regular payments from the buyer (in most cases, in addition to an upfront payment), and in turn assumes the risk that the underlying debt will not be repaid. In the event of default, the seller of the contract has to reimburse the buyer for the unpaid interest and the principal of the debt.[1]


Credit default swaps are non-standardized private contracts between the buyer and the seller. They are not traded on any exchange, and have remained unregulated by any government body. The International Swaps and Derivatives Association (ISAD) publishes guidelines and general rules that can be used to write CDS contracts.

The International Swaps and Derivatives Association estimates the total notional amount of outstanding credit default swaps to be around $ 62.2 trillion, making these contracts the most widely traded credit derivative product, as of December 2007.[2]. However as it is the case with other derivative instruments, notional amounts don't represent the actual amount that is exchanged through CDS.

Due to the lack of regulation in the market for CDS, these instruments had been underwritten by almost any financial institution. Large insurers such as American International Group (AIG) and Ambac Financial Group (ABK) have been major players in the market in the past. However, such contacts are also written by hedge funds, mutual funds and banks such as Merrill Lynch (MER), Citigroup (C) and Morgan Stanley (MS).

Underlying assets can theorically be any type of assets. Sovereign debt and financial companies' debt are the most commonly used assets with Italy, Spain and General Electric Company (GE) being the top-three entities in term of net notional amount.

How Credit Default Swaps Work

Credit default swaps have a buyer who pays a seller in exchange for protection against default on a 12 month loan.

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Size of the CDS market [3]

Typically, payments (i.e. the seller would have to pay the buyer) under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong.

For example, suppose an investor owns a corporate bond from Apple that yields 8%. The investor is exposed to a number of risks that could lead to default (e.g. the bond issuer goes bankrupt). In order to protect himself, investor purchases CDS on Apple bonds from AIG on this bond. In exchange, he agrees to pay out a portion of the bond's yield to AIG. Now, for some reason, if Apple is unable to pay its interest on the bond, AIG has to pay the CDS holder the entire par value of the bond.

Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.

If an investor buys a CDS from a financial firm with good credit, the CDS does indeed act as a hedge against default risk.

What is the purpose of a CDS?

In exchange for the protection against default, the insurer receives a regular payment from the buyer. This is typically a percentage of the coupon payments on the bond. Effectively, while the buyer receives protection, he gives up a portion of his interest receipts to the insurer.

CDS does not have to be bought in conjunction with the underlying bond. Since, in the event of a default, the writer of the CDS reimburses the buyer the entire principal amount, these contracts can be used for speculative purposes. For example: if an investor believes that Lehman Brothers (LEH) would be unable to pay its creditor, he could just buy a CDS to bet on this position. This has led to use of these swaps for speculative activities.

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