Credit Default Swaps for Dummies - Part I: Single Name CDS

A few people have asked me about what a Credit Default Swap is and what J P Morgan did with them.  As for the latter question it is not clear that we know the specifics yet but the articles that I have linked to below shed some light on what they may have done.  As for the former question that takes a bit of work.  So here is my version of Credit Default Swaps for Dummies (Part I).

Say you buy a bond from IBM.  You pay 100 USD for it today.  They promise to pay you your 100 USD back in May 2014 and along the way they will pay you  1USD per year in coupon payments.  That 1 USD per year reflects two components (1) the general level of return that you would demand from a risk free lender like say the US Government and (2) a risk premium above the risk free return that you will demand because it is possible (unlikely but possible) that IBM could default on you.

Now you are pretty happy with receiving 1 USD per year for lending your money but you are a bit nervous that IBM could default on you or that the bond otherwise loses value.  So what you really would like to do is hedge away some of the risk.  Before looking at how to hedge the risk let's look at what these risks are again.  You face two primary risks by holding that IBM bond 

(1) there is the risk that the general level of interest rates go up and the price of your bond will then go down.  If you hold the IBM bond to maturity you will still get your 1 USD per year and your 100 USD back in two years.  However if you tried to sell the bond before maturity you would find that you would get less than 100 USD for it.  Why?  If the general level of interest rates has gone up then you could go out into the new bond market and pay 100 USD for a new bond which pays 100 USD at maturity and pays MORE than 1 USD per year along the way (remember we assumed interest rates went up).  So no one is going to pay you 100 USD for your bond that only pays a measly 1 USD per year when they can pay 100 USD for a new bond that pays more than 1 USD per year.  Hence the value of your bond will fall below 100 USD.  That is interest rate risk.

(2) there is the risk that IBM will in someway default on your bond - or in CDS speak that they will experience a "credit event".  Maybe they miss a coupon payment along the way or they don't pay you back your 100 USD at maturity.  There is also the possibility that IBM gets their credit downgraded along the way.  Now IBM getting their credit downgraded does not necessarily mean you don't get your 100 USD at maturity and your 1 USD along the way - but if you tried to sell your 1 USD bond prior to it's maturity the chances are that you would not get 100 USD for it.  This is credit risk.

So now say you want to hedge the risk on your bond how would you do that?  Well there are many ways to hedge the interest rate risk (shorting US Treasuries, selling US Treasury futures, US Treasury futures options, Eurodollar futures and options - these are huge very liquid markets).   But hedging the credit risk of IBM is a bit more difficult.  You could try to short another IBM bond but that may be cost prohibitive.  You could ask someone to write you a put option on your bond.  So in that case if the value of your IBM bond falls below some value (say 90 USD) you could put the bond back to the person who sold you the option in return for 90 USD.  Of course you don't get the option for free - you would have to pay some premium for the option.  The problem with the put option is you have to get someone to write you an option on the specific bond that you hold - and that may be expensive.  Furthermore you are paying them to insure you against both credit risk and interest rate risk when there are cheap ways to hedge away the interest rate risk.  What you really want is a way to specifically hedge away the credit risk.  Enter the credit default swap!

So you go to your local credit default swap dealer and ask him to write you a credit default swap (CDS) on IBM.  You want is a single name CDS ie a CDS which is specific to IBM as opposed to a basket or index or more complicated structure.  There are also two types of CDS physical settle and financial settle.  The original CDS were physical settle and they are easier to understand...but today in the US most CDS are financial settle.

How does a physical settle CDS work?   You would agree to pay your local CDS dealer a coupon rate (say 0.2% per year) on a notional amount (we want to protect 100 USD) for a certain amount of time (in our case two years).  So you would pay the dealer (100 USD*0.2% =  ) 0.20 USD per year for two years.  If at any point prior to the expiration of the CDS if a "credit event" occurs then you would have the right to hand your IBM bond over to the CDS dealer in return for the principle value of the bond (100 USD) and then the CDS ends.  The agreement with the CDS dealer will spell out exactly what constitutes a credit event as well as exactly which bonds you can hand over to the dealer - you may have a choice of a few bonds.

Now it is possible that you could decide to sell your IBM bond prior to the expiration of your CDS agreement or maybe you never even owned the bond in the first place.  But you can still purchase a CDS on that bond.  Then if a credit event were to trigger your CDS agreement you could go out into the market and buy a IBM bond (which should be selling cheap since it is in default or has had its credit downgraded) and turn that bond in to the CDS dealer in return for the principle value ($100) of the bond. In that case you are actually hoping the value of the bond does goes down.  That is called a naked CDS - where you have CDS protection on a bond that you don't actually own. 

How does a financially settled CDS work?  Again you would agree to pay your local CDS dealer a coupon rate (say 0.2% per year) on a notional amount (we want to protect 100 USD) for a certain amount of time (in our case two years).  If IBM were to experience a credit event prior to the expiration of your CDS then instead of you turning your bond in to the CDS dealer in return for 100 USD you would instead receive from the CDS dealer a payment for the difference between the principle amount (100 USD) and what the bond is currently selling for after the credit event has been announced.  In order to decide what the official current selling price for the bond is there is a poll of bond dealers which attaches a price to the bond.  Most US CDS are financially settled now.

So now you have a way to hedge the credit risk on a bond separate from the interest rate risk.

Why did people like CDS so much?

First they do allow you to separate the two components of corporate bond risk and hedge as much or as little of each as we want.

Second they allow someone to speculate on the credit risk of a company.  One can argue whether or not this is a good thing or not.

Finally the general structure of a credit default swaps allows banks to hedge their exposure to one of their customer's company credit.  Say Bank Wobbo loans IBM 1BB USD for working capital.  Bank Wobbo decides  they want to hedge some of that risk.  How could they do that?   One way would be for them to buy a CDS on IBM from another party.  As long as either (1) the bank loan has priority in liquidation over IBMs corporate loans or (2) default on the bank loan constitutes a credit event - if IBM defaults on that bank loan then Bank Wobbo would be able to collect on their CDS.   There are similar CDS like structures which are specific to bank loans but they are less liquid than the standard CDS.  Credit default swaps give banks an easy way to insure themselves against customer's defaulting on them.