CHAPTER 11

Introduction to Credit Default Swaps and Synthetic CDOs

In this chapter we describe the basic workings of credit default swaps (CDS) and synthetic CDOs. These products have grown tremendously since 1996 in terms of both trading volume and product evolution. Specifically, the volume of outstanding credit CDS rose from $20 billion in 1996 to $2.3 trillion in 2005. In 1997, $1 billion of synthetic CDOs had been created (including funded, unfunded, and CDS index tranches); by 2005 there were over $1 trillion of synthetic CDOs outstanding.

In terms of product evolution, CDS have developed from highly idiosyncratic contracts taking a great deal of time to negotiate into a standardized product traded in a liquid market offering competitive quotations on single-name instruments and even indices of credits worldwide. Synthetic CDOs have evolved from vehicles used by commercial banks to offload commercial loan risk to customized tranches where investors can select the names they are exposed to, the level of subordination that protects them from losses, and the premium they are paid (although not all three simultaneously).1 Finally, the rise of standardized tranches on CDS indices has increased trading liquidity, thereby allowing long-short strategies based on tranche seniority or protection tenor.

CREDIT DEFAULT SWAPS

The dramatis personae of a CDS are: a credit protection buyer, a credit protection seller, a reference obligor, and reference obligations. What tie these parties ...

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