The Art of Credit Derivatives: Demystifying the Black Swan

4

Credit Default Swaps

The four most expensive words in the English language are “This time it’s different.”

John Templeton

4.1 INTRODUCTION

The most fundamental credit derivative instrument is the credit default swap. In its plain form the instrument provides single name insurance in case of a default event of an underlying reference. The importance of this instrument to the recent financial activity can be seen by the sheer speed of its growth. As Table 22.1 shows, the market for individual name CDSs has grown from about USD 200 billion in 1997 to around USD 25 trillion in 2008, according to ISDA.

To understand how a CDS functions, consider an investor who has bought a 10-year bond from a company X. In order to protect herself against a default event on the reference entity of the bond the investor buys a 10-year CDS from a counterparty on the specific bond she has bought. Under the CDS contract the investor pays a fee, usually every quarter, until the end of the contract or until a credit event on the bond happens. Where there is a credit event the protection seller pays par to the protection buyer while receiving the defaulted bonds. In the case of cash settlement the protection seller pays par minus the recovery value of the bond, that is, she pays the loss given default (LGD).

Observe that a CDS is a synthetic instrument or, more precisely, it is an insurance contract, and no cash may need to be put up front, that is, there is no cost of funding. Depending on specific ...