Credit Default Swap (CDS)

MarketWatch  Nov 17  Comment 
The rate at which U.S. consumers defaulted on their auto loans, mortgages and other credit rose in October, according to a report by S&P Dow Jones Indices and Experian released Tuesday. The composite consumer credit default rate rose five basis...
Cellular News  Oct 20  Comment 
TeliaSonera's five-year Credit Default Swaps (CDS) widened 73% Thursday to price at the widest levels observed in four years, Click here for more.
Forbes  Oct 7  Comment 
Protection costs on the debt of quick-service restaurant operator Yum! Brands (NYSE: YUM) today reached the highest readings in more than six years after the company late yesterday slashed its earnings forecast for 2015 amid a...
Wall Street Journal  Oct 1  Comment 
Wall Street’s biggest banks have agreed to pay $1.86 billion to settle accusations that they conspired to prevent competition in the credit derivatives markets.
Mondo Visione  Sep 23  Comment 
The International Swaps and Derivatives Association, Inc. (ISDA) today announced that its EMEA Credit Derivatives Determinations Committee resolved that a Potential Repudiation/Moratorium has occurred in respect to the Republic of...
New York Times  Sep 11  Comment 
Twelve major banks have reached a $1.865 billion settlement to resolve investor claims that they conspired to fix prices and limit competition in the market for credit default swaps, a lawyer for the investors said on Friday.
Financial Times  Sep 11  Comment 
Agreement follows claims of collusion over $16tn credit default swaps market
Financial Times  Sep 8  Comment 
ICE to join others in launching CDS trading platform


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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