A CDS is sometimes chosen when a bank manages the credit risk of its loans, or when an investor holding corporate bonds wants to reduce that risk.

Exchanging a premium for compensation of losses

A credit default swap (CDS) is a derivative trade used to buy and sell the credit risk of a company or a country. The company or country it covers is called the reference entity. If a bankruptcy or a failure to pay at the reference entity is recognized as a credit event, the protection seller pays the protection buyer and makes up for the buyer's loss. This promise to make up for the loss is called protection, and the money the buyer pays the seller in return is called the premium. For the buyer, the effect is similar to paying a fee for a guarantee1.

The level of the premium is expressed as an annual rate, and this rate is also called the CDS spread. The spread is usually quoted in bp (basis points; 1bp is 0.01%)2.

Consider a hypothetical example in which Bank X has lent 10 billion yen to Company A. Bank X buys protection through a 5-year CDS with Company A as the reference entity and a notional amount of 10 billion yen. The spread is 50bp (0.5% a year), and the premium is paid every 3 months. A CDS is an OTC derivative that does not go through an exchange, and Bank X and the seller enter into it bilaterally34.

Company ARef. entityBank XCDS buyerSellerCDS sellerLoan JPY 10bnRepaymentsPremium 50bpEvent payout
Figure 1Bank X hedging its loan to Company A with a CDS
Figure description

Bank X lends 10 billion yen to Company A, the reference entity ("Ref. entity" in the figure), and receives principal and interest from Company A. Bank X pays the protection seller a premium at a spread of 50bp. The seller pays Bank X only if a credit event occurs at Company A. Company A is not a party to the CDS and takes no part in its payments.

Payments with and without a credit event

If no credit event occurs, Bank X only keeps paying the premium and receives nothing from the seller. Under the example's terms, each premium payment is 10 billion yen × 0.5% ÷ 4 = 12.5 million yen. According to an IHS Markit document from November 2021, a CDS premium is usually paid every 3 months5. Over 5 years, Bank X makes 20 premium payments totaling 250 million yen.

If a credit event occurs, the seller pays an amount that makes up for the buyer's loss. There are two ways to settle. In physical settlement, the buyer delivers bonds or other debt of the reference entity to the seller, and the seller pays their face value. In cash settlement, the price of the reference entity's debt is determined, and the seller pays the difference between face value and that price6. In the example, if cash settlement sets the price of Company A's debt at 30% of face value, the seller pays Bank X 10 billion yen × (100% − 30%) = 7 billion yen. The types of credit events and the auction procedure that sets the price of the debt are covered in Credit Events and Settlement.

↑ Receive　↓ PayBank X, the protection buyer3M6M9M1YSettlement−JPY 12.5mnPremium−JPY 12.5mnPremium−JPY 12.5mnPremium−JPY 12.5mnPremium+JPY 7bnSettlement
Figure 2Bank X's payments and receipts when a credit event occurs after the premium payment at 1 year
Figure description

The figure shows the payments and receipts of Bank X, the protection buyer. Bank X pays a premium of 12.5 million yen at 3 months, 6 months, 9 months, and 1 year. After the payment at 1 year, a credit event occurs at Company A. If the price of Company A's debt is set at 30% of face value, Bank X receives 7 billion yen from the seller on the settlement date. No further premiums are paid after that. The length of each arrow is a rough guide to the size of the amount.

Once a credit event has occurred, the premium payments stop7. The profit and loss of Bank X and the seller depend on whether an event occurs, as follows.

Case Total premiums paid by Bank X Payment received by Bank X Bank X's profit or loss on the CDS Seller's profit or loss on the CDS
No event for 5 years 250 million yen 0 yen −250 million yen +250 million yen
Event after the payment at 1 year (price 30%) 50 million yen 7 billion yen +6.95 billion yen −6.95 billion yen

If no event occurs, Bank X recovers its loan to Company A in full and has only paid 250 million yen in premiums on the CDS. Suppose an event occurs and Bank X recovers 30% of face value, or 3 billion yen, from its loan to Company A. Together with the 7 billion yen from the CDS, that makes 10 billion yen. In this case, Bank X gets back its principal of 10 billion yen, and it has paid 50 million yen in premiums for the CDS. The seller is in the opposite position: it keeps receiving premiums if no event occurs and makes a large payment if one does.

Value changes with the reference entity's credit quality

Like the prices of bonds and loans, the value of a CDS changes with the credit quality of the reference entity8. In the example, suppose Company A's business worsens and the spread on a CDS with the same terms rises from 50bp to 200bp. Bank X holds protection at 50bp that would now cost 200bp, so the value of its CDS rises. The seller has taken on the risk at 50bp when it could now receive 200bp for it, so it has a loss. If Company A's credit quality improves and the spread falls, the gain and loss are reversed9.

The example so far assumes that the buyer keeps paying the premium at the spread fixed at the trade date. According to the IHS Markit document from November 2021, a CDS premium is paid at a fixed coupon, and an amount equal to the difference between the current spread and the coupon changes hands at the trade date10. The coupon and the upfront payment (the payment at the trade date), and how to derive the value of a CDS from the likelihood of a credit event (the hazard rate) and the recovery rate, are covered in Pricing a CDS.

Uses

A CDS is used to hedge the credit risk of loans and other claims the buyer holds (buying protection) and as an investment that takes on credit risk to earn premiums (selling protection). It is also used for trading that seeks to profit from price changes11. Banks buy protection to reduce the credit risk of their loans. As in the Bank X example, a bank can transfer only the credit risk while keeping the loan on its books12.

The protection buyer does not need to hold the reference entity's debt. For this reason, investors who expect the entity's credit quality to worsen, and investors who hold its shares, also buy protection13. There are also CDS indices, which cover several reference entities together5.

A CDS that has a country as its reference entity is called a sovereign CDS. According to the Bank of Japan's Financial Markets Report of January 2010, a sovereign CDS is not traded in the currency of the country it covers and is usually denominated in US dollars. Entities of the covered country's nationality do not, as a rule, sell protection on it, because buyers want to avoid the country and the seller failing at the same time14. Financial institutions buy protection to manage their risk limits for each country and to reduce the credit risk of the government bonds they hold14. Around the end of 2009, spreads on sovereign CDS rose for Greece and other countries whose fiscal deficits had grown sharply15.

Risks of a CDS

The protection buyer bears the credit risk of the seller. Around the 2008 financial crisis, most CDS were bilateral trades between the two parties, and if the seller had failed by the time a credit event occurred, the buyer risked not being paid16. After Lehman Brothers failed in September 2008, protection sellers on CDS with Lehman Brothers as the reference entity became obliged to pay a little over 90% of face value. At that time, there were concerns that seller failures could spread in a chain16. In October 2008, the Financial Stability Forum recommended setting up a central counterparty for CDS that would stand between buyers and sellers16.

There is also a risk that the hedge does not work as expected. The conditions for a credit event in a CDS are generally not the same as the default terms in bond and loan contracts, so a loan can suffer a loss without any payment from the CDS8.

For the protection seller, the risk is that the payment on a credit event is very large compared with the premiums it receives. In the example, the seller receives 50 million yen a year in premiums but pays 7 billion yen if an event occurs.

Differences from corporate bonds

Selling protection through a CDS and buying a corporate bond both take on the credit risk of the reference entity, but they differ in the following ways.

Item Buying a corporate bond Selling protection through a CDS
Funds needed at the start The purchase price of the bond Less cash on hand than buying the bond17
Need to hold the reference entity's debt Holds the bond itself Not needed (the same applies to the buyer)6
Credit-related events covered Principal or interest not being paid when due Credit events in the CDS (which may include restructuring)
Credit risk taken on Credit risk of the bond's issuer Credit risk of the reference entity plus the risk that the counterparty fails18

Restructuring, in the third row of the table, means changing the terms of a debt, such as reducing the interest rate or extending the maturity1. Because a CDS may include it, a CDS can cover a wider range of events18.

How the CDS market grew

New credit risk transfer products, starting with CDS, spread in the US and European markets from the mid-1990s19. CDS were first created so that investors such as holders of corporate bonds could hedge credit risk. Once prices came to be set in the market, trading that seeks to profit from price changes grew sharply20. Trading grew rapidly after a standard contract using the definitions published in 1999 by the International Swaps and Derivatives Association (ISDA) took hold19. After the 2008 financial crisis, settlement that sets the price of the debt through an auction became the industry standard from April 2009621.

Notes

  1. 中山貴司 and 河合祐子, "クレジット市場の発展に関する一考察" (A study of the development of the credit market, in Japanese; Bank of Japan, Bank of Japan Review 2005-J-4, March 2005), "BOX1 クレジット・デフォルト・スワップ（CDS）の仕組み" (Box 1: How a credit default swap (CDS) works), page 2. ↩ ↩2

  2. Financial Markets Department, Bank of Japan, "信用リスク移転市場の新たな展開" (New developments in the credit risk transfer market, in Japanese; マーケット・レビュー 2003-J-2, January 2003), Chart 3 (page 4). Federal Reserve Bank of New York, "Credit Default Swap Auctions," Figure 1 (page 23). Japan Securities Clearing Corporation, "Markit iTraxx Japan 本日のスプレッド" (Markit iTraxx Japan: today's spreads, in Japanese), "スプレッド表記" (Spread notation). ↩

  3. Financial Markets Department, Bank of Japan, "信用リスク移転市場の新たな展開" (in Japanese), "市場の透明性とリスク分布" (Market transparency and the distribution of risk), page 5. ↩

  4. 吉井一洋, "クレジット市場における検討課題" (Issues to consider in the credit market, in Japanese; Financial Research and Training Center, Financial Services Agency, 2009), "5.3.3 米国財務省の金融規制改革報告書" (5.3.3 The US Treasury's financial regulatory reform report), page 50. The source includes CDS among OTC derivatives. It notes that it gives the author's personal views, not the official views of the Financial Services Agency. ↩

  5. IHS Markit, "CDS Indices Primer" (November 2021), page 4, "What is a CDS?" and "How does it work?" ↩ ↩2

  6. 吉井一洋, "クレジット市場における検討課題" (in Japanese), "5.1.1 CDS とは" (5.1.1 What is a CDS), page 46. ↩ ↩2 ↩3

  7. Federal Reserve Bank of New York, "Credit Default Swap Auctions," the table in "Box 2: Relationship between the CDS premium and the credit spread on a bond" (page 22). ↩

  8. Bank of Japan, "金融市場レポート" (Financial Markets Report, in Japanese; January 2010), "BOX6 デフォルト局面における信用リスク商品の連動性" (Box 6: How credit risk products move together around defaults), pages 37–38. ↩ ↩2

  9. OpenGamma Quantitative Research, "The Pricing and Risk Management of Credit Default Swaps, with a Focus on the ISDA Model" (October 2013), Section 2.2 (page 3), Section 4.5 (page 10), and equation (28). ↩

  10. IHS Markit, "CDS Indices Primer" (November 2021), page 5, "What is the fixed coupon and upfront amount?", and page 9, "Fixed coupons, upfront amounts and quoted spreads." ↩

  11. 中山貴司 and 河合祐子, "クレジット市場の発展に関する一考察" (in Japanese), "CDS 市場の構造" (Structure of the CDS market) and Chart 2, page 2. ↩

  12. Financial Markets Department, Bank of Japan, "信用リスク移転市場の新たな展開" (in Japanese), "能動的な信用リスク管理の実施" (Active credit risk management), page 1. ↩

  13. Federal Reserve Bank of New York, "Credit Default Swap Auctions," page 1. ↩

  14. Bank of Japan, "金融市場レポート" (Financial Markets Report, in Japanese; January 2010), "BOX3 ソブリン CDS 市場について" (Box 3: The sovereign CDS market), page 17. ↩ ↩2 ↩3

  15. Bank of Japan, "金融市場レポート" (Financial Markets Report, in Japanese; January 2010), "（ドバイ・ショックなどへの国際金融資本市場の反応）" (Reaction of international financial and capital markets to the Dubai shock and other events) under "Ⅰ．国際金融資本市場の改善持続と政策対応" (I. Continued improvement in international financial and capital markets and policy responses), page 16, and Chart I-1-23. The period analyzed runs to the end of December 2009. ↩

  16. 吉井一洋, "クレジット市場における検討課題" (in Japanese), "5.2.1 2008 年金融危機と集中清算機関設立の提言" (5.2.1 The 2008 financial crisis and the proposal to set up a central clearing house), page 47. ↩ ↩2 ↩3

  17. Financial Markets Department, Bank of Japan, "信用リスク移転市場の新たな展開" (in Japanese), "新たな投資・資金調達機会の提供" (New opportunities for investment and funding), page 2. ↩

  18. Financial Markets Department, Bank of Japan, "信用リスク移転市場の新たな展開" (in Japanese), "CDS プレミアムと社債スプレッドの比較" (Comparing CDS premiums and corporate bond spreads), pages 3–4. ↩ ↩2

  19. Financial Markets Department, Bank of Japan, "信用リスク移転市場の新たな展開" (in Japanese), the summary (page 1), "市場の概況" (Market overview, page 2), and "BOX2 CDS 市場・CDO 市場の動向及び参加者" (Box 2: Trends and participants in the CDS and CDO markets, page 3). ↩ ↩2

  20. 吉井一洋, "クレジット市場における検討課題" (in Japanese), "5.1.2 CDS 市場の拡大" (5.1.2 Growth of the CDS market), page 46. ↩

  21. Federal Reserve Bank of New York, "Credit Default Swap Auctions," page 2 and footnote 4. ↩