What is Credit Default Swap?
A Credit Default Swap (CDS) is a financial derivative, or contract, through which an investor can “swap” their credit risk with another investor. These derivatives pay off when the issuer of an instrument (e.g., a corporate bond, mortgage-backed securities, any fixed income instrument) defaults. CDS works like an insurance policy where the buyer is required to pay an ongoing premium payment to the seller. The buyer gets protection against an unlikely event thereby, mitigating the risk. However, Credit Default Swap is also used for speculative purposes. It is not necessary to own an asset to buy CDS.
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During the 2007-08 financial crisis, Lehman Brothers filed for bankruptcy, it owed $600 billion of which CDS covered $400 billion. The seller of these swaps i.e. American International Group (AIG), Pacific Investment Management Company, and the Citadel hedge fund didn’t have enough cash to cover their swap contracts. This shows credit risk wasn’t eliminated but transferred to the CDS seller. The biggest risk is when sellers and borrowers default at the same time, and this was the preeminent cause of the 2008 crisis.
In a nutshell, the buyer of the swap makes regular payments till maturity to swap seller and in return, the swap seller agrees to pay the buyer if the issuer defaults or credit event occurs like insolvency, bankruptcy, failure to pay, etc. thus, resulting in termination and settlement of the contract. The amount of settlement depends on the terms of the contract. The settlement of the contract can either be a physical settlement or a cash settlement.
Physical Settlement
Earlier, credit events were settled through physical settlement. It means the buyer of the swap will deliver the actual bonds to the seller of the swap. This is possible only if the buyer holds the underlying asset. In this scenario, the seller will pay the buyer face value of the asset, and the buyer will in return give the underlying asset to the seller.
For example, An Investor (buyer) enters into CDS with the CDS seller for a bond worth $1,000,000. Assume that there is an event of default because of which the recovery rate of the bond is 30%. Now with the physical settlement, the buyer will hand over these bonds (worth $300,000) to the seller and receive a payment of $1,000,000.
Cash Settlement
As CDS grew and the use of CDS contracts increased, a more efficient way for settlement got introduced i.e. cash settlement. In case of a cash settlement, the seller will pay the buyer full face value less the current value of the asset thus compensating the decline in value of the asset. For example, An Investor buys a bond worth $1,000,000. Assume a recovery rate of 30%, the CDS seller pays compensation of $300,000 to the CDS buyer if the company defaults.
Lehman Brothers Auction: After Lehman Brothers’ failure in 2008, the auction set a price of 8.625 cents per dollar for their debt. It means the seller of the swap will pay 91.375 cents per dollar. The buyer would have been able to recover only 8.625 cents per dollar, only after the conclusion of the bankruptcy process. However, as the buyer had already taken protection, he will receive 91.375 cents per dollar. (As discussed, a buyer will get face value less the current value of the asset).
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The Auction Mechanism
In the auction mechanism, the single recovery price is determined for the underlying debt and the investors can either make a cash settlement or a physical settlement. All the CDS trades in the auction are cash-settled at a final auction price. The auction process has two stages.
In the first stage, dealers post bid-ask rates for the underlying debt for a pre-set amount and spread to set inside market midpoint (IMM). After the IMM has been set, open interest (net buy or sell request) is calculated. If the open interest is zero, then the final recovery price is equal to the IMM. The open interest from the first stage is carried over to the second stage of the auction as limit orders (it is a type of order to buy or sell securities for a better price).
In the second stage, which is the Dutch auction process, the open interest is matched with the limit orders to determine the final price. If the open interest is to buy, then the lowest sell limit order is matched and if the open interest is to sell, then the highest buy limit order is considered. This process continues till all the open interests are met or limit orders are exhausted. If open interests are met, then the last limit order used for open interest is the final price. If limit orders are exhausted and open interest is to buy then the final price will be at par value and if the open interest is to sell then the final price will be zero.
Author: Swati Krishnamurthy
About the Author: Swati is a freelance writer. She is a Financial Quality Compliance specialist having integrated knowledge and experience in Logistics, Audit, and Risk-mitigation for manufacturing and service sectors. Her passion for finance grew as she scored centum in financial management during her master’s degree. She’s a classical dancer who performs to express complex emotions through her dancing and writes to express complex concepts into simple words.
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