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.