Credit Derivatives & Credit Default Swaps
A credit default swap is insurance on a borrower's debt. It lets investors trade pure credit risk — stripped of the risk-free rate and funding — and was at the centre of the 2008 crisis. This lesson covers CDS mechanics and settlement, how a CDS differs from a corporate bond, the structured-credit market (CDOs and tranches), and the main credit-derivative trading strategies.
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Credit derivatives are instruments whose payoff depends on the creditworthiness of a borrower. The credit default swap (CDS) is the building block — roughly half the market. It is a bilateral contract in which a protection buyer pays a periodic premium to a protection seller, who agrees to compensate the buyer if a credit event (bankruptcy, material default, debt restructuring) hits a specified reference entity. The protection buyer is long the CDS but short the credit; the seller is short the CDS but long the credit.
Learning outcomes
- Describe the characteristics of a CDS and contrast it with a corporate bond.
- Explain the advantages of credit derivatives over other credit instruments.
- Explain how the various market participants use credit derivatives.
- Discuss the main credit-derivative strategies and how they are used.
1–2 · What a CDS is
Like fire insurance on a house, a CDS pays out only on disaster. The buyer pays an annual premium (quoted in basis points on the notional, normally paid quarterly on the standard IMM dates — 20 Mar/Jun/Sep/Dec). If no credit event occurs, the contract simply runs to maturity. If one does, it settles either:
- Physically — the buyer delivers the defaulted (reference) obligation and receives par; or
- In cash — the buyer receives par minus the recovered market value of the obligation.
A Volkswagen CDS
5-year CDS on €10m of Volkswagen debt at a 60 bp premium.
Show solution
Annual premium \(=0.60\%\times€10\text{m}=€60{,}000\), paid quarterly. No credit event → it runs the full five years. A credit event → physical settlement (deliver VW debt for par) or cash settlement (receive par − market value).
€60,000/yr premium; pays out only on a VW credit event2.1 · CDS vs corporate bond — pure credit risk
A corporate bond's yield bundles three things: the risk-free rate, funding risk (the swap spread), and credit risk. An asset swap strips out the risk-free rate, leaving funding + credit. A CDS isolates credit risk alone — e.g. a VW bond at Treasuries+100bp, a VW asset swap at LIBOR+60bp, and a VW CDS at a flat 60bp. The CDS spread widens as perceived credit risk rises and tightens as it falls.
Portability of pure risk — buying protection is an efficient way to short credit, which is otherwise hard (shorting corporate bonds is difficult). Liquidity — CDS create maturity, currency, and credit exposures not readily available in the cash market. Confidentiality — unlike a loan, the reference entity is not a party to the bilateral OTC contract.
Market growth & participants. The market grew explosively once documentation was standardised and legal risk fell. It is dominated by banks (buy protection to hedge loan books and free up regulatory capital), hedge funds (active relative-value traders, the fastest-growing and most liquidity-providing segment), insurers (major protection sellers, for yield and diversification), and corporations (risk management and balance-sheet/pension uses).
2.4 · The structured-credit market
Structured credit is the fastest-growing segment. A collateralised debt obligation (CDO) pools credit exposures and redistributes the risk into tranches. A synthetic CDO references a portfolio of CDS rather than holding cash bonds, and can be customised or index-based.
Losses hit the most junior tranche first. The equity tranche (e.g. 0–3% of the iTraxx Europe) absorbs the first losses and earns the highest spread; once it is wiped out, the next (mezzanine, then senior, then super-senior) tranche begins absorbing losses. More subordination → lower spread → safer tranche. This is how a pool of risky credits is sliced into pieces of very different risk.
3 · Credit-derivative strategies
3.1 Basis trades
The cash-default basis is the CDS premium minus the bond's asset-swap spread. Positive basis = CDS richer; negative basis = CDS cheaper, a potential arbitrage. Investors look for ~10–20 bp of upside (a couple of bps isn't worth it). Example: buy a 5-year British American Tobacco bond at LIBOR+60bp and buy 5-year CDS protection at 46bp → a negative-basis package of 14 bp of "free" carry (with residual basis risk if the legs don't perfectly match).
3.2 Curve trades
Express a view on how a credit profile changes over time, built either default-neutral (matched notionals) or duration-neutral. A flattener buys short-dated protection and sells long-dated (good long-term credit, short-term worry); a steepener is the reverse (bearish long-term but minimising near-term negative carry).
3.3 Index trades
Credit indices (e.g. Dow Jones iTraxx Europe) are efficient, cheap, diversified, and liquid. Uses: an outright short to hedge a portfolio; long-index vs short a sub-sector/specific names; inter-sector relative value (autos vs telecoms); or a macro capital-structure trade (long a credit index, short an equity index).
3.4 Options on CDS
European-style options on credit. A receiver option is the right to sell protection (bullish on credit — profits as spreads tighten); a payer option is the right to buy protection (bearish — profits as spreads widen). They are the building blocks for straddles, strangles, and other strategies.
3.5 Capital-structure trades
Exploit perceived mispricing within one issuer's capital structure — holding company vs operating company/financial subsidiary, or senior vs subordinated debt. Examples: sell Ford Motor Credit 5-year CDS at 400bp and buy the parent's at 525bp, expecting the 125bp gap to widen; or, bullish on US housing, sell Fannie Mae subordinated CDS at 30bp and buy senior protection at 15bp for +15bp carry. Credit-vs-equity trades use the Merton model, which treats a firm's equity as a call option on its assets.
3.6 Correlation trades
Default correlation — the chance two credits default together — is the key input for synthetic CDOs. Low correlation concentrates risk in the equity tranche; high correlation pushes it up into the senior tranches. Correlations are estimated from history or implied from traded index tranches.
An FTD basket pays out on the first name in a basket to default — a leveraged credit view. With five names each near 50bp, a diversified CDS portfolio pays ~50bp, but an FTD basket pays ~175bp (typically 60–80% of the aggregate spread), because a default of any name triggers it. If each name has a 3% default probability, the chance none defaults is \(0.97^5\approx85.9\%\), so the basket has a ≈14.1% chance of being triggered. On default, the contract ceases and the buyer delivers the notional in the defaulted name — it behaves as if the investor had written a contract on that single name.
Investors also trade slices of the synthetic-CDO capital structure against each other (e.g. long the 0–3% equity tranche, delta-hedged with mezzanine or single-name CDS) to harvest the large positive carry of the equity tranche while neutralising spread (DV01) exposure and idiosyncratic default risk.
A CDS is insurance that isolates pure credit risk — the buyer pays a basis-point premium and is made whole on a credit event, by physical or cash settlement. Stripped of the risk-free rate and funding, credit becomes a tradeable asset class: basis trades arbitrage CDS against bonds, curve and index trades express timing and macro views, options and capital-structure trades take directional or relative-value positions, and correlation/FTD trades and CDO tranches package default correlation itself. Powerful for managing and enhancing return — and, as 2008 showed, powerful enough to amplify systemic risk.