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What is a credit default swap? - Part 1 Back  
CreditTrade, the financial services information provider offers an introduction to credit default swaps (CDS) – contracts which provide users with a contractual mechanism for transferring the credit risk inherent in bonds, loans and other credit intensive instruments without disturbing the structure or legal ownership of the underlying asset.
To fully understand a credit default swap (CDS) requires a minimum breadth of knowledge encompassing the mechanism, usage, and limitations.

Product description
In a CDS the buyer of protection typically pays a periodic fee in exchange for the seller of protection contracting to make a payment should a pre-agreed corporate or sovereign borrower suffer some kind of pre-agreed credit crisis.

There are a number of credit events that can be included in the contract: a bankruptcy by the reference credit or a restructuring or failure to pay by a pre-agreed asset or assets (reference obligation issued by the reference credit.

Following a credit event there are two main ways of settling the contract: cash settlement and physical delivery. Cash settlement is a formulaic payment equal to the par value of the reference obligation minus its post-default trading value as determined by a pre-agreed dealer poll mechanism. Physical delivery involves the transfer of a pre-agreed asset or assets (deliverable obligation) to the seller in exchange for a payment equal to the notional of the contract.

The uses of credit derivatives are broadly divided between risk management and investor applications. The former applies to situations where the user is a buyer and hence is reducing credit exposure though not necessarily motivated entirely by risk reduction; the latter applies to situations where the user is a seller and hence is increasing credit exposure.

Risk management applications: When applied to credit derivative usage the term ‘risk management’ is misleading as so many transactions have little to do with the management of risk. However, since the common thread is the synthetic transfer of credit risk it is convenient to lump such transactions under the same heading. Generally speaking these different types fall into four categories: risk reduction, line management, balance sheet management and capital management.

Risk reduction: The most obvious and indeed common usage of a CDS is to reduce credit risk in a situation where the user is concerned for the credit quality of the credit that is being hedged. This could arise where an internal credit analyst produces research with a negative view on the reference credit and the portfolio manager chooses to hedge actual exposures or where a trader takes a negative view on a credit, sector or region and chooses to put on a short position by buying protection.

Line management: In contrast to risk reduction, CDSs are often used to reduce credit exposure in a situation where the user is very positive about the credit quality of the credit being hedged but due to internal limit issues there is insufficient credit line to allow a planned transaction. The CDSs is therefore used to manage the credit line of the borrower in question and the need for a hedge arose because of a positive view of the reference credit.

Balance sheet management: Whereas risk reduction and line management are primarily motivated by a positive or negative view on the credit being hedged, balance sheet management has little to do about credit views and limits and everything to do with managing the optics of a corporate balance sheet. By selling assets and retaining the risk through CDSs a user can effectively rent a third party’s balance sheet, move assets off balance sheet and hence reducing financing needs.

Capital management: The fourth so-called ‘risk management’ motivation for using a CDS is capital management. This is primarily a bank application given the requirement by all banks to report regulatory capital usage and by some banks to monitor economic capital usage. In either case the hedging of assets can reduce capital usage and frequently this is the prime motivation for using a CDS.

The management of regulatory capital is widely practised and has been addressed by most national bank regulators. Subject to a number of criteria, which vary somewhat between different regulators, a bank may hedge a risk-weighted asset with a CDS and reduce the risk weighting to that of the hedge counterparty or to zero if the transaction is effectively cash collateralised.

The management of economic capital is practised by few and is not currently regulated. However, such activity is highly significant and can only increase with time. Since an economic capital model will reveal portfolio risks due to risky assets, large holdings and correlated holdings, and the universe of recommended hedges is far greater. Furthermore, since no two banks portfolios look the same a recommended hedge on one portfolio may look like a recommended investment on another - a rare example of a financial ‘free lunch’ since both sides of the transaction are motivated by portfolio diversification.

Investor applications: Access to new assets - A prime investor motivation for using a CDS is the ability to source credit risk that ordinarily would not be available. The very nature of the product enables credit risk to be separated from its underlying asset thus removing many of the structural barriers inherent in the more traditional credit markets. Hence a non-bank investor can use CDSs to access the loan market, a sector previously unavailable. Since the majority of borrowers issue in the loan market but not in the bond market, the implications for ‘bond investors’ is significant.

Leverage: The other major investor motivation for using CDSs is leverage. This benefit comes in many guises. The most obvious benefit is the absence of any financing when using a CDS: a credit investment can be made with no associated funding. Should return on investment be a deciding parameter it is obvious that the CDS would be compelling since, aside from a possible need to post collateral, there is no need for an up-front investment. In addition the removal of a financing leg allows investor to invest in better-rated investments and achieve much need portfolio diversification. The traditional credit markets make this difficult since a single ‘A’ rated bank probably funds at a higher spread than the return on double ‘AA’ rated assets.

The requirement to finance assets forces the single ‘A’ bank to invest in weaker credit with wider financing costs. This is not appealing in the context of portfolio management and the arrival of the CDS was embraced because it significantly increased the ability of medium strength banks to invest in high quality corporates.

Obstacles and limitations
Counterparty credit risk: The transacting of CDSs often suffers from the so-called ‘credit paradox’ whereby credit risk tends to be concentrated with the institutions best able to originate it although basic portfolio theory would recommend the reverse. So too CDSs are often easiest and cheapest to contract with the least suitable counterparties. Those institutions that know the reference credit best are likely to have existing exposures and therefore may present increased correlation risk; those institutions that are least demanding on price are those with weaker balance sheets and higher funding costs and hence are attracted to the off-balance sheet nature of the investment. Weak correlated counterparties whilst keenest to deal are of course the least suitable from a counterparty credit risk perspective.

It follows that the best counterparties are often hardest to transact with since on the one hand very low correlation may be because the institutions is not familiar with the reference credit and hence needs to be ‘sold’ the full credit story; on the other hand due to its financial strength it may find the return on a funded assets more appealing due to its ability to fund the assets at levels below Libor supply and demand.

Whilst the structure and theoretical usage of CDSs presents the financial markets with a valuable new product that appeals to many, a substantial obstacle to its usage is supply and demand for transactions. The very reasons that may incentivise a portfolio manager to hedge - the reference credit is illiquid, complex or deteriorating - may also discourage potential investors. Similarly whilst investors are drawn to the better credits with attractive risk-return profiles, so too are the risk managers and they will only sell such credits when credit lines or regulatory capital are constrained.

Pricing and valuation: There is no consensus in the market on the model to use for pricing CDSs. A common methodology is to use the Asset Swap spread for the reference credit in the maturity of the CDS contract and to adjust it up or down based on factors such as expected financing rate and liquidity.

Suppose that the benchmark interbank rate is Libor and that the funding rate for a risky bond is also Libor. Consider a transaction where an investor has a long position in a risky bond earning Libor +50bp hedged with a CDS. Ignoring counterparty risk, the net effect of this transaction is to mitigate the investor’s default risk exposure to the risky bond. Hence, the default protection should cost the investor 50bp.

If the CDS spread is less than 50bp, the investor can buy the bond, finance it at Libor and buy default protection to earn a small positive return for no risk. Similarly, if the default swap spread is higher than 50bp, the investor can short the bond, sell default protection and receive a small positive return. In reality the market does not present such ideal positions and pricing is affected by bond liquidity and difficulties associated with shorting risky bonds. However, this basic approach is the favoured starting point for pricing and is likely to become more meaningful as liquidity moves from the bond market to the credit derivative market.

Future potential
The CDS market continues to show significant growth not only in the volume of transactions done but also in the universe of credits that are traded and in the breadth of counterparties active in the market. This is likely to continue for a number of years as the proportion of underlying credit risk that has been ‘mobilised’ by credit derivatives is still very small - probably in the order of a few percentage points. In contrast the interest rate swap markets is multiples of its underlying cash market.

A significant boost to the market will be the implementation of Basle II. Whilst the regulations may not come into place until 2005 or 2006, many institutions will start to re-shape their portfolios as soon as the new rules are agreed on and published. Basle II will bring many changes but the rules most likely to impact the CDS market are those relating to risk weightings. In contrast to the 1988 Basle Capital Accord, bank capital under Basle II will be a function of the credit quality of a bank’s risk assets. Initially the measure of this credit quality will be public credit ratings but it is expected that this will migrate to internal ratings and ultimately to model based capital charges.

This is likely to result in two major changes: first, banks will, generally speaking, find corporate assets more appealing and weak OECD bank and sovereign assets less appealing. This will result in some significant portfolio adjustments in the run up to Basle II implementation and will likely change the dynamics of the bond market thereafter; secondly, due to ratings migration, the regulatory capital allocated to an asset may change over the life of the asset making the asset suddenly less attractive or indeed substantially more attractive. Since many banks use return on regulatory capital as a performance measure, the incentive to hedge will increase where, due to a credit downgrade, the regulatory capital charge doubles and the return hence halves.

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