Derivatives

CHAPTER 42Credit Default Swaps (CDS)

Aims

• To explain the operation, uses and pricing of credit default swaps (CDS).
• To analyse the use of the iTraxx (Europe) and CDX (USA) credit indices.
• To analyse forwards and options on the CDS spread.

Credit derivatives allow companies and financial institutions to hedge their credit risks and allow investors to hold assets whose value depends (in part) on the creditworthiness of companies and individuals. The increased use of credit derivatives was very rapid over the 2000–7 period, slowed down after the credit crisis of 2008 but has since substantially revived.

Banks issue loans to companies and individuals and if these default, the banks experience losses. There are two main ways banks can reduce their credit risk. First, they can ‘bundle up’ a portfolio of loans and sell bonds to investors (e.g. pension funds, insurance companies, sovereign wealth funds) who then receive the cash flows from the loans – this is securitisation, and is discussed in Chapter 43.

The second way a bank can reduce risk arising from a specific corporate loan is to retain the loans in its banking book but to buy protection against a default by the corporate. It can do this by purchasing a (single name) credit default swap (CDS), often from an insurance company. If the corporate defaults on its bank loan, the seller of the CDS (insurance company) will compensate the bank for any losses on the defaulting loan. There are also basket CDS where you can buy credit ...