The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

WHAT ARE CREDIT DEFAULT SWAPS?

The typical analogy used for a credit default swap (CDS) is an insurance contract. The purchaser of insurance is buying financial protection against a specified event. For example, a homeowner buys earthquake or flood insurance to “hedge” against a catastrophic event. CDS can be considered a policy used to “hedge” against corporate default.

That said, there are important differences between CDS and insurance contracts. For example, can you imagine a homeowner buying flood protection that pays out in the event of a flood impacting a neighbor’s home rather than his or her own? Or how about a homeowner buying protection on a neighbor’s house in an amount five, six, or seven times the value of his or her neighbor’s home?

It is difficult to envision these things in the context of the insurance market, but these are certainly components of the CDS market. For example, in theory CDS buyers can purchase an unlimited amount of contracts on an underlying reference entity (although if risk managers are doing their jobs, this would not occur). As such, CDS is a way to not only hedge risk, but also a way to take risk—and levered risk at that. Moreover, because homeowners do not necessarily mark-to-market flood insurance that they may have purchased on their (or their neighbor’s) house, it cannot be used to protect against other assets being damaged in the event of bad weather (e.g., a boat docked in a nearby lake). But CDS is typically marked-to-market, ...