Credit default swaps are meant for hedging risk. But they could also lead to disaster. Imagine what would happen if you took a jump believing that you were carrying a parachute but, in mid-air, pulled the lever and discovered, to your shock, that the parachute had a big hole.
Shailaja and Manoj K Singh
Even expert skydivers of the credit market may fall like empty vessels if their parachutes of credit default swaps have a big hole. The problem is that by the time the hole is discovered, it may be too late.
Jinny: Hi Johnny! Why are you staring at the sky?
Johnny: Whenever I am thinking, I stare at the sky. That really helps.
Jinny: But staring at the sky will not make the answers fall from somewhere. You can always ask me if you have any questions.
Johnny: Okay, tell me about credit default swaps.
Jinny: Credit default swap, or CDS, needs no introduction. It is a kind of bilateral derivatives contract that the financial world discovered in the mid-1990s. But today the whole financial sky seems to be full of CDS.
Like any other over the counter, or OTC, derivatives contract, CDS contracts are negotiated directly between two parties but most of these contracts follow the standard terms and conditions of the International Swaps and Derivatives Association (Isda), which makes them look like a standardized product. One party of the CDS contract is called the protection buyer while the other party is called the protection seller. Protection buyers are mostly banks and financial institutions but protection sellers could be anybody with an appetite for risk taking, such as hedge funds and monoline insurers in the US. In all CDS contracts, a protection buyer transfers his credit risk to a protection seller.
Johnny: Credit risk? What’s that? And how can it be transferred?
Jinny: Well, credit risk is the risk involved in all transactions of borrowing and lending. If you lend money, what are the chances that the borrower will make the repayment? Or, look at this way: When you buy a pair of shoes, there is always a chance that they may start pinching your feet.
In case the borrower is likely to promptly return the money, then you have a low credit risk, and in case there is a high probability of default then you have a high credit risk. So each borrowing and lending has its own element of risk involved.
Lenders generally charge high interest rates from risky borrowers. A credit default swap enables lenders or protection buyers to transfer this credit risk to the protection seller in exchange for fees that are often paid periodically. The protection seller, on his part, undertakes to make good the loss suffered by the protection buyer in the case of a credit event such as default or failure of the borrower to repay the loan to the protection buyer. In that case, the protection seller makes the repayment. So a credit default swap resembles an insurance policy. You pay the premium and the insurance company undertakes to make good your loss.
Johnny: So, everything depends on the happening of the credit event. If no default occurs then the protection seller would not make any payment, right?
Jinny: Yes, that’s right. Once the credit event has taken place, the parties to the credit default swap have three options of settling their obligations. The first option is what is known as physical settlement. Under this option, the protection buyer hands over the defaulted loan or bond to the protection seller in return for the face value of the defaulted loan or bond. Take my pinching shoes and give me a full refund.
The second option is what is known as cash settlement, which requires mutual consent and understanding between the parties. In a cash settlement, actual loans or bonds are not handed over to the protection seller.
In the shoes analogy, it would be like me keeping the pinching shoes but you making good my loss.
The payment of cash is made after making an assessment of the present recoverable value of the defaulted loan or bond. This obviously difficult job is done by some specialized people, also known as calculation agents in popular terminology. If the present recoverable value of a Rs100 loan or bond is Rs60, then the protection seller would pay you Rs40 in cash settlement.
Johnny: What’s the third option of settling a CDS contract?
Jinny: The third option is to settle the contract by fighting it out. What makes you think that your shoes are pinching? Well, there could be thousands of reasons to disagree. Moreover, any promise written on a piece of paper is only as good as the person writing that promise. If the person writing that promise is dead, what would you do? Further, obligations under CDS contracts can be easily transferred to third parties and by the time you knock at his doors, the protection seller himself may have moved out. Instead, some stranger answers the door. Wouldn’t you be shocked?
Johnny: That would be shocking indeed. Something like jumping out of a plane and discovering that instead of a parachute, you are holding a straw.
What: Credit default swap (CDS) is a kind of bilateral derivatives contract that is used to hedge the risk of default in a loan or credit.
Who: One party to the CDS contract acts as the protection buyer while the other party acts as the protection seller.
How: CDS is negotiated directly on the basis of standard terms and conditions of the International Swaps and Derivatives Association.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com