Credit Default Swaps

Explore MacroVar quantitative analytics and database of more than 1000 Corporate, Sovereign Credit Default Swaps and Credit Default Swaps indices.

MacroVar risk management models monitor credit risk levels across the US, Europe and Emerging markets by monitoring individual credit default swaps and credit default swaps indices presented below (CDX, ITRAXX)

Credit Default Swaps Database

Credit Default Swaps Explained

Parties Involved

• Protection Buyer: This party pays a periodic fee (similar to an insurance premium) to the protection seller.
• Protection Seller: This party agrees to compensate the protection buyer in case the reference entity (the borrower) defaults on its debt.

Reference Entity

The entity whose credit risk is being transferred. This is typically a corporation or a government.

Premium Payments

The protection buyer makes regular payments to the protection seller. These payments are usually made quarterly and are calculated as a percentage of the notional amount of the CDS.

Credit Event

A trigger event such as a default, bankruptcy, or restructuring that leads to the protection seller having to pay the protection buyer.

• Initiation: The protection buyer and seller enter into a CDS contract. They agree on the notional amount (the amount of debt being protected) and the premium payments.
• Premium Payments: The protection buyer makes periodic payments to the protection seller.
• Credit Event: If a credit event occurs, the protection seller compensates the protection buyer. This can happen in two ways:
  • Physical Settlement: The protection buyer delivers the defaulted debt instrument to the protection seller in exchange for the notional amount.
  • Cash Settlement: The protection seller pays the protection buyer the difference between the notional amount and the recovery value of the defaulted debt.

Credit Default Swap example

An investor holds a portfolio of corporate bonds yielding 6% and wants to get protected for the event of default. Rather than incur the expense of liquidating the portfolio, it is more efficient to protect his portfolio by purchasing a 1-year protection. The investor will buy a 1-year credit default swap by paying a premium (insurance premium) of 2% to keep the principal safe in the event of default over the next 1-year. If there is no credit event, like the default during the life of the swap, insurance premiums will be paid from the investor to the protection seller. If a credit event occurs the protection seller is obliged to make a payment to the protection buyer.

Types of CDS

• Single-name CDS: Protects against the default of a single reference entity.
• Index CDS: A CDS that provides protection on a basket of reference entities. For example, the CDX index covers North American corporate credits.
• CDS on Mortgage-backed Securities: These CDSs provide protection against defaults on mortgage-backed securities.

Pricing of CDS

The cost of a CDS (i.e., the premium payments) depends on several factors:

• Credit Quality: The lower the credit quality of the reference entity, the higher the premium.
• Economic Conditions: In times of economic uncertainty, CDS premiums tend to rise.
• Supply and Demand: The demand for credit protection can affect the pricing of CDS.

Uses of CDS

• Hedging: Investors use CDS to hedge against the risk of default on debt instruments they own.
• Speculation: Traders can use CDS to speculate on the creditworthiness of a reference entity. If they believe the entity’s credit quality will deteriorate, they can buy protection and profit if the CDS premium rises.
• Arbitrage: Investors can exploit price discrepancies between the CDS market and the bond market for the same reference entity.

Risks of CDS

• Counterparty Risk: The risk that the protection seller will default on their obligation.
• Market Risk: Changes in market conditions can affect the value of the CDS.
• Legal and Operational Risks: Risks related to the enforceability of the CDS contract and operational issues in managing the contracts.