Credit Default Swap (CDS)

Financial Times  Jul 27  Comment 
Trading volumes in credit default swaps tied to the electric carmaker have jumped
Financial Times  May 30  Comment 
Hovnanian will make bond payments as Blackstone’s GSO settles case with Solus
Mondo Visione  Apr 11  Comment 
The International Swaps and Derivatives Association, Inc. (ISDA) today published a statement from its Board of Directors on reported instances of narrowly tailored credit events and a process to consider improvements to the efficiency of the...
Mondo Visione  Mar 9  Comment 
At the request of Chicago Mercantile Exchange Inc. (CME) and ICE Clear Credit LLC (ICC), the Commodity Futures Trading Commission (CFTC) issued an order today approving the transfer of all open interest in credit default swaps (CDS) at CME to...
Mondo Visione  Dec 1  Comment 
CFTC's Weekly Swaps Report has been **REVISED**, and is now available. The CFTC Swaps Report provides a detailed weekly snapshot of the gross notional outstanding as of the penultimate Friday prior to the CFTC Swaps Report’s Wednesday...
Financial Times  Nov 9  Comment 
Ruling on credit default swaps expected on Friday as PDVSA payments are not received
Mondo Visione  Nov 2  Comment 
The OFR issued a working paper, titled, “How Safe are Central Counterparties in Derivatives Markets?” This paper uses credit default swap data to estimate the direct and indirect impacts of a default by CCP counterparties in derivatives...
SeekingAlpha  Sep 1  Comment 
Wall Street Journal  Aug 29  Comment 
A dispute over credit default swaps written on the embattled commodity trader’s debt is exposing the limitations of the system governing such products.


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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