What Are They?
A Credit Default Swap or a CDS Contract is just a derivative contract between two parties or people. These contracts come in various forms and time frames. What typically happens is that a buyer of a CDS contract pays the seller a payment (premium) and in return receives a payoff (In the event of a default) of the underlying asset. Basically its an insurance contract between two parties, with the caveat that the buyer doesn't really have to own the underlying asset being insured.
But in most cases, a normal swap contract is enacted as a way to hedge or limit losses due to interest rate or credit volatility.
The first Credit Default Swap contracts were invented at J.P. Morgan in 1997.
Historically the default rate on CDS Contracts are around 0.17% for Investment Grade Companies. This is the main reason why most Quantitative Models created never modeled for mark to market accounting or total default.
Credit default swaps were seen as easy money for banks and other financial institutions when they were first launched more than a decade ago. The reason? The economy was booming and corporate defaults were few back then, making the swaps a low-risk way to collect premiums and earn extra cash. The swaps focused primarily on municipal bonds and corporate debt in the 1990s, not on structured finance securities. Investors flocked to the swaps in the belief that big corporations would seldom go bust in such flourishing economic times.
The CDS market then expanded into structured finance, such as CDOs, that contained pools of mortgages. It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. They're betting on whether the investments will succeed or fail. It's like betting on a sports event. The game is being played and you're not playing in the game, but people all over the country are betting on the outcome.
How They Work?
For example:
I have a car for which I buy insurance in the event of a accident. This is a normal insurance policy. The way a CDS Contract works is that I (Buyer) would buy a CDS contract underwritten versus my friend (Underlying Asset) who I know is a bad driver. Another friend (Counter Party) writes the contract. I pay the counter party a fee (Premium) as protection against my friend getting into a serious accident. If my friend continues to obey all driving rules and avoids accidents, the premium generally will stay constant for the life of the contract, and the counter party continues to collect "Risk Free Premiums". But if my friend gets into a serious accident, the premiums will sky rocket and my CDS Contracts are making money as the contract is more valuable. The counter party is now liable not only for any damages caused by the driver but also has to make up the difference (Mark To Market) the contract is now worth.
The idea or the reason to buy or sell these type of contracts is to take advantage of the price or spread that the buyer or seller is currently quoting.
For Example:
I am buying $1mm worth of protection against my friend, I pay 100 basis points to the seller. I then pay the seller $10,000 for the CDS Contract. I make money if the driver gets into an accident, and the premium shoots up to 300 basis points. The contract is now valued at $30,000, and I have a profit of $20,000. The seller is not only liable for the losses stemming form the accident, but also has to put up a margin (%Difference between 10K and 30K) to me.
CDS contracts don't trade on any regulated exchange, thus are not normally registered or regulated...This is what makes the counter party risk that we are experiencing. There was never a regulating body exercising any control on who is buying or selling these type of derivative contracts.
In theory, the higher the CDS associated with a company, the higher chance of default or bankruptcy.
Like most financial instruments, CDS are created and formed for:
1- Speculation
2- Hedging / Insurance
3- Arbitrage
CDS are traded over the counter between 2 people or dealers who are trying to gain an advantage with regards to the spread within a given period of time.
If a credit event does occur, one of two things can happen:
1-Physical Settlement - The seller pays the buyer par value for the debt being insured, and the buyer delivers the bonds.
2-Cash Settlement- The seller pays the difference between par and the current market price for the bonds being insured.
If in the event a large default takes place where many CDS Contracts are underwritten, an auction settled by the International Swaps and Derivatives Association (ISDA) takes place.
Also in the event of a default, because of the heavy trading volume inherent with CDS Instruments, the secrecy involving CDS transactions, and most importantly the lack of any regulation, an original CDS instrument can go through 20-25 trades, so when a default occurs, the so-called insured party or hedged party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default.
What Is The Market?
Year End Values - Source: International Swaps and Derivatives Association (ISDA)
2001: $918 billion
2002: $2.2 trillion
2003: $3.8 trillion
2004: $8.4 trillion
2005: $17.1 trillion
2006: $34.4 trillion
2007: $62.3 trillion
2008: $54.6 trillion
The total market capitalization of all publicly traded companies in the world was US$51.2 trillion as of January 2007.
The Total US Mortgage Market is roughly $10 Trillion in 2008
As of 2008 the size of the international bond market was $48 Trillion
The U.S. Bond Market has roughly $30 Trillion of debt outstanding as of 2008
You get the picture!
Recent 2009 Figures - $27.5 Trillion
More and more of these contracts are being either offset and settled because of bankruptcy, insolvency, auctions, or mark downs.
In 2008, The top 25 Largest Banks held $13Trillion in CDS obligations. acting either as the insurer or insured.
What Are the Benchmarks?
The most liquid instruments in the CDS Market are the benchmark indexes that reference the 5 Year Debt of companies.
Markit iTraxx Europe - based on 125 European investment-grade companies
Markit iTraxx Crossover - based on 50 European companies mostly junk-rated with stable outlook
Markit CDX IG -based on 125 investment-grade North American companies
Markit CDX HY -based on 100 North American companies that do not rank as investment grade
Part 2 We Will discuss what happened to the CDS Market that contributed to the Global Credit Meltdown.
No comments:
Post a Comment