Why Credit Default Swaps?

Imps and Impetus In this article, I will give a few explanations as to why credit default swaps, Satan’s financial tool of choice, exist.

That Which I Do Not Understand Must Be Evil There are formal rules of logic which distinguish between sound arguments and fallacies. Although most of us are not conscious of these rules, I would like to think that somewhere in the recesses of all human minds there is at least an abstract appreciation for these rules, despite the fact that we often argue and act with complete disregard for their existence. That said, we should expect more from those who claim to know things. Those who claim to know things should be able to explain exactly how it is that they know these things. Yet, for some reason, it has become acceptable for pundits discussing credit default swaps to claim to know that credit default swaps have no bona fide economic purpose simply because they cannot come up with one. So, rather than outlining the path to their knowledge, such pundits concede failure in their search for knowledge, and then infer that because of this failure, the knowledge sought after does not exist. I’m no logician, but I’m fairly certain that argument rests upon the assumption that these pundits know everything.

The Advantage Of Unfunded Instruments As a general matter, credit default swaps are unfunded. That is, the protection seller does not post the notional amount of the contract into an account for the benefit of the protection buyer. This allows the protection seller to invest that amount elsewhere, earning a return. If the notional amount is posted or held in Treasuries, then the cash flows received by the protection seller will be roughly equivalent to the cash flows of the reference obligation on which he has sold protection. This is because the protection seller will earn the risk free rate on the Treasuries and will receive the swap fee from the protection buyer, which should be approximately the spread over the risk free rate that the underlying reference obligation pays. So in a fully funded CDS, the protection seller earns the risk free rate plus a spread. This is explained in greater detail here. But if the protection seller invests an amount of cash equal to the notional amount in non-risk free instruments, he will be able to earn a return above the risk free rate, in addition to earning the swap fee, which implies that the total return will be higher than that of the underlying reference obligation. So in the case of an unfunded CDS, the protection seller earns a return above the risk free rate plus a spread. Thus, credit default swaps allow for unfunded exposure to credit risk, which facilitates a return that is higher than the underlying bond.

The Advantage Of Simplified Documentation Credit default swaps also offer the advantage of simplified and standardized documentation, which allows market participants to precisely tailor the credit risks to which they are exposed. The document templates are prepared and published by the International Swaps and Derivatives Association, and then modified by market participants to define the terms of particular transactions. So ISDA publishes standardized forms, and then market participants customize the forms to reflect their individualized needs. Because almost all credit default swaps are based on the same form, it makes review and comprehension easier and faster, which reduces transaction costs.

The Advantage Of Contract Credit default swaps are contracts, and so the rights and obligations of each party can be whatever the parties agree to. This allows for the creation of essentially infinite variations on the basic credit default swap theme. For example, rather than name a single reference obligation, a CDS could name a group of different bonds, known as a basket, on which protection is to be sold. This allows the protection seller to gain exposure to a basket of credit risks and the protection buyer to receive protection on that same basket. And this is done without either party purchasing a single bond.

Another common variation is the n-th to default CDS. In an n-th to default CDS, protection is bought on a basket of reference obligations, but the protection buyer only receives payment from the protection seller upon the occurrence of n defaults. So if n = 3, the protection buyer will only receive payment upon the 3rd default of the reference obligations in the basket. In an ordinary CDS, n = 1, since payment is made upon the 1st default. There are variations on this theme as well. For example, the CDS could be structured so that payment occurs only upon the n-th default, terminating the agreement. Alternatively, payment could be made for the n-th default and all defaults after that. It is up to the parties to decide how the deal is structured.

The point in both of these examples is that because swaps are rooted in contract, they offer a level of customization that would be prohibitively expensive and in some cases impossible using traditional financial instruments. If you can come up with a method of simulating an n-th to default CDS using only traditional instruments, please impress us all in the comment section.

Originally published at Derivative Dribble and reproduced here with the author’s permission.

14 Responses to "Why Credit Default Swaps?"

  1. interested reader   January 15, 2009 at 4:43 pm

    Please impress us with your joint correlation estimate at any point in time first.

  2. Guest   January 15, 2009 at 9:02 pm

    In discussing the “Advantage of Unfunded Instruments” you describe the situation where the seller invests the notional amount in various securities. What if the seller does not have assets equal to the notional amount to invest anywhere? I thought this was the real life shortcoming in many of these situations.

  3. NashG   January 15, 2009 at 11:48 pm

    Hi,thanks for the information.Actually i am not having any idea about this.So,this can be very useful for us.Home Loans

  4. Anonymous   January 16, 2009 at 6:34 am

    I’ll admit, I haven’t understood these things, and get dizzy when people start to explain them. This helps. Bottom line, sounds like basic sorghum and pork bellies. If so, it should at the very least conform to that market’s rules.Is that oversimplification, or what?

  5. rc whalen   January 16, 2009 at 7:31 am

    No, CDS are not like sorghum and pork bellies. Most commodity contracts and OTC derivatives are true contracts where there is an exchange of value between the parties. CDS are gaming instruments where one party pays and the other pays IF an event occurs. These are “barrier options” where default requires the party to fund the purchase of the notional collateral less recoveries. There are two basic problems with this model.First, CDS contracts are priced vs’ short terms bond spreads and/or volatility, and they are commonly used for one leg of an equity volatility type trade. But this fact is in conflict with the underlying terms of the contract, namely the requirement to fund the entire net value of the underlying basis. So in the case of Fannie/Freddie, default resulted in a small funding requirement since the recovery rates was in the 96-98 cent range. With Lehman/WaMu, the opposite situation exists and providers of CDS protection were required to fund payouts of 96+ cents on the dollar of par value. Since the pricing provided by the short term market spreads in no way provide enough consideration to cover the risk of funding a default event by the underlying credit, the only way to look at these instruments is that of highly speculative, even reckless instruments.The other issue is correlation. CDS contracts have a close to 1:1 correlation with the broad markets. Unlike traditional “low beta” types of insurance riusk (ship sinkings, huricanes, floods), CDS is high-beta risk and cannot be priced using normal risk industry models. Indeed, since we are ultimately talking about hedging a corporate bond that cannot be borrowed at any cost, the real question to ask about CDS is why we bother at all. The answer is that CDS is yet another fraud foisted upon investors by a Wall Street community that, like the CDS contracts themselves, have little connection to the real economy..

  6. Derivative Dribble   January 16, 2009 at 9:25 am

    RC,”the only way to look at these instruments is that of highly speculative, even reckless instruments.”Nonsense. Selling fully funded protection is economically equivalent to owning the underlying bond. So, it follows from your argument that bonds are reckless instruments.

  7. Derivative Dribble   January 16, 2009 at 9:29 am

    Anonymous,You can think of credit default swaps as conditional forward contracts. That is, delivery only occurs upon the occurrence of some event. But economically, the easiest way to think about CDSs is to look at the protection seller as long on the bond and the protection buyer as short on the bond.If the protection seller invests the notional amount in Treasuries, he will have almost the same cash flows as the underlying bond.

  8. Anonymous   January 19, 2009 at 2:27 pm

    “Selling fully funded protection is economically equivalent to owning the underlying bond”This is irrelavant nonesense to Chris Walen’s point. In practice, CDS aren’t funded. As if the sellers store the notional safelely in a riskless deposit box, so it can be retreived to meet obligations? The seller enter into CDS exactly because they don’t need to fully fund protection. Read what CW is saying: “namely the requirement to fund the entire net value of the underlying basis”

  9. Derivative Dribble   January 20, 2009 at 4:52 pm

    Anonymous,Chris Walen’s first point is nonsense. There are estimated recovery values on bonds. These apply equally to CDSs. If they’re no good for CDSs, they’re no good for bonds.His second point is also nonsense. CDSs are no more correlated than the underlying bonds, which are more correlated to general market risk than tornadoes and fires, but market participants should know that.I made the point that fully funded protection is equivalent to owning the bond because it implies the two points made above.As to funding, collateral is posted over the life of the agreement depending on who is in the money. Additionally, the PROTECTION BUYER WILLINGLY ASSUMES THE RISK THAT THE COUNTERPARTY WILL NOT PAY. This is priced into the agreement using upfront collateral.

  10. WhoseNephewIsThisGuy   January 20, 2009 at 8:50 pm

    D Drivel,Its just painful to watch. Is RGE open to anybody with a search engine nowadays. C.W. has actual experience, he raises good points informed by actual experience. You respond by copy/pasting stuff from wikipedia/google. He doesn’t need a defense against the mechanical Turk (“fully funded protection is equivalent to owning the bond” – we got it – we took that class – it’s not the point). suggest you google: counterparty PFE, beta, wrong way expsosure.

  11. Derivative Dribble   January 21, 2009 at 9:33 am

    WhoseNephewIsThisGuy,What does future counterparty exposure have to do with anything? The risk that your counterparty will not perform is an obvious one. That risk changes as a function of market conditions. Wow, what and insight. Any other gems you’d like to share? That is the case in any contract, bond, or any business arrangement.Your idiotic comment evidences a misunderstanding of not only my article, but CW’s comment. His comment on correlation had nothing to do with counterparty risk. He was viewing CDS protection sellers as insurers, noting that CDSs have risks which are highly correlated to overall market risk. This is a fair point, but the reality is you shouldn’t treat CDSs as insurance, but as long credit positions.As to my professional experience, I don’t list my affiliations because I don’t need morons like you harassing me at work.

  12. Anonymous   January 21, 2009 at 10:38 am

    I actually think Derivative Dribble makes a pretty good point. His points are economic and based on modeling the value of the instrument. Counterparty risk is priced into everything.WhoseNephewIsThisGuy makes a lame argumentum ad verecundiam point in favor of CW (look that up on wikipedia, hotshot). That’s not a respectable position – wall street is really doing wonderfully right now, so all these seasoned veterans must have really added a lot of value through their extensive experience. Also, that’s never a valuable

  13. Anonymous   January 21, 2009 at 12:00 pm

    Anonymous,CDS contracts don’t price, or at least looking back they have not, the fully-loaded counterparty exposure risk. That’s true if you know about these and it is related to c.w.’s first point, although his point is more specific. It may be hard to understand if you have no experience with how CDS (and margin collateral) work in practice.I did have to look up ad verecundiam (appeal to authority). That’s not WhoseNephew’s point. The argument is about empiricism:people with some experience on a matter may have better information that people with no experience (or who are using just a textbook to parrot basic finance). The argument btwn cw and dd is like an argument about fishing btwn a pro fisher and somebody whose only read about fishing in a book; the former can say “hey fish are over on this part of the lake, this is how they tend to eat” while the latter is arguing with you that fish aren’t mammals b/c they don’t lay eggs (because that’s what’s in his textbook; fully funded protection is like owning a bond).

  14. Derivative Dribble   January 21, 2009 at 12:49 pm

    Anonymous, or WhoseNephewIsThisGuy,”CDS contracts don’t price, or at least looking back they have not, the fully-loaded counterparty exposure risk.”Wow. Really? You mean the market underpriced risk? Gee, I think I may have heard that somewhere. Looking back, as you said, the entire financial system underpriced risk. This is not unique to CDSs. See MBSs, CDOs, etc.”It may be hard to understand if you have no experience with how CDS (and margin collateral) work in practice.”First off, WC’s point had nothing to do with collateral. His point had to do with funding. If a CDS is funded, the cash is there regardless of who’s in the money.Second, in practice, it’s not called “margin collateral” in the context of derivatives. It’s simply called “collateral.”And, in practice, FYI, the movement collateral is governed by the terms of the Credit Support Annex to the Schedule which amends the ISDA Master Agreement between the parties. I also learned that from the text book I read every day at work, when I’m not actually working on derivatives deals.