A credit default swap CDS is a financial swap agreement that the seller of the CDS will compensate the buyer usually the creditor of the reference loan in the event of a loan default by the debtor or other credit event. That is, the seller of the CDS insures the buyer against some reference loan defaulting.

The buyer of the CDS makes a series of payments the CDS "fee" or "spread" to the seller and, in exchange, receives a payoff if the loan defaults.

It was invented by Blythe Masters from JP Morgan in In the event of default the buyer of the CDS receives compensation usually the face value of the loan , and the seller of the CDS takes possession of the defaulted loan. If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction ; the payment received is usually substantially less than the face value of the loan.

Credit default swaps have existed since , and increased in use in the early s. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. CDS data can be used by financial professionals , regulators, and the media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies.

Courts may soon be following suit. Most CDSs are documented using standard forms drafted by the International Swaps and Derivatives Association ISDA , although there are many variants. In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset-backed securities. Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency.

A CDS is linked to a "reference entity" or "reference obligor", usually a corporation or government. The reference entity is not a party to the contract.

The buyer makes regular premium payments to the seller, the premium amounts constituting the "spread" charged by the seller to insure against a credit event.

If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's credit rating. Five years is the most typical maturity. In this way, a CDS is similar to credit insurance , although CDS are not subject to regulations governing traditional insurance.

Also, investors can buy and sell protection without owning debt of the reference entity. These "naked credit default swaps" allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity.

A "credit default swap" CDS is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection.

If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor actually owns Risky Corp's debt i. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp see Uses.

If the reference entity i.

The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount.

For example, if the CDS spread of Risky Corp is 50 basis points , or 0. Payments are usually made on a quarterly basis, in arrears. These payments continue until either the CDS contract expires or Risky Corp defaults.

All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs having to perform under these contracts.

CDS contracts have obvious similarities with insurance, because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs. However, there are also many differences, the most important being that an insurance contract provides an indemnity against the losses actually suffered by the policy holder on an asset in which it holds an insurable interest.

By contrast a CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. The holder does not need to own the underlying security and does not even have to suffer a loss from the default event. When entering into a CDS, both the buyer and seller of credit protection take on counterparty risk: As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or both parties to a CDS contract must post collateral which is common , there can be margin calls requiring the posting of additional collateral.

The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require payment of an upfront fee composed of "reset to par" and an "initial coupon.

Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers.

Data about the credit default swaps market is available from three main sources. Data on an annual and semiannual basis is available from the International Swaps and Derivatives Association ISDA since [26] and from the Bank for International Settlements BIS since According to DTCC, the Trade Information Warehouse maintains the only "global electronic database for virtually all CDS contracts outstanding in the marketplace.

The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U. S commercial banks and trust companies. Credit default swaps can be used by investors for speculation , hedging and arbitrage.

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as the North American CDX index or the European iTraxx index.

An investor might believe that an entity's CDS spreads are too high or too low, relative to the entity's bond yields, and attempt to profit from that view by entering into a trade, known as a basis trade , that combines a CDS with a cash bond and an interest rate swap. Finally, an investor might speculate on an entity's credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases.

The investor might therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company's creditworthiness might improve.

Credit default swaps opened up important new avenues to speculators. Investors could go long on a bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default. For example, a hedge fund believes that Risky Corp will soon default on its debt. Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses.

Transactions such as these do not even have to be entered into over the long-term. If Risky Corp's CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts. Credit default swaps are also used to structure synthetic collateralized debt obligations CDOs.

Instead of owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS. An example of a synthetic CDO is Abacus AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April In the examples above, the hedge fund did not own any debt of Risky Corp. Legislation is under consideration by Congress as part of financial reform.

Analogizing to the concept of insurable interest , critics say you should not be able to buy a CDS—insurance against default—when you do not own the bond. Because naked credit default swaps are synthetic, there is no limit to how many can be sold.

Despite these concerns, Secretary of Treasury Geithner [17] [39] and Commodity Futures Trading Commission Chairman Gensler [41] are not in favor of an outright ban on naked credit default swaps. They prefer greater transparency and better capitalization requirements.

Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace. Without speculators buying and selling naked CDSs, banks wanting to hedge might not find a ready seller of protection. A robust market in credit default swaps can also serve as a barometer to regulators and investors about the credit health of a company or country. Despite assertions [ citation needed ] that speculators are making the Greek crisis worse, Germany's market regulator BaFin found no proof supporting the claim.

A bill in the U. Congress proposed giving a public authority the power to limit the use of CDSs other than for hedging purposes, but the bill did not become law.

Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection.

If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt. There are other ways to eliminate or reduce the risk of default. The bank could sell that is, assign the loan outright or bring in other banks as participants. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants.

If both the borrower and lender are well-known and the market or even worse, the news media learns that the bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely damage the banker-client relationship.

In addition, the bank simply may not want to sell or share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. Another kind of hedge is against concentration risk. The bank can lay off some of this risk by buying a CDS.

Because the borrower—the reference entity—is not a party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. A bank buying protection can also use a CDS to free regulatory capital. This frees resources the bank can use to make other loans to the same key customer or to other borrowers.

Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons. In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables. Although credit default swaps have been highly criticized for their role in the recent financial crisis , most observers conclude that using credit default swaps as a hedging device has a useful purpose.

Capital Structure Arbitrage is an example of an arbitrage strategy that uses CDS transactions. However, if its outlook worsens then its CDS spread should widen and its stock price should fall.

Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.

An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain situations. Therefore, a basic strategy would be to go long on the CDS spread by buying CDS protection while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity.

An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a Leveraged buyout LBO.

Frequently this leads to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying a premium.

Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as:. The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero.

Basis trades can aim to exploit any differences to make risk-free profit. Forms of credit default swaps had been in existence from at least the early s, [49] with early trades carried out by Bankers Trust in A team of J.

Morgan bankers led by Blythe Masters then sold the credit risk from the credit line to the European Bank of Reconstruction and Development in order to cut the reserves that J. Morgan was required to hold against Exxon's default, thus improving its own balance sheet.

BISTRO was the first example of what later became known as synthetic collateralized debt obligations CDOs. Securities and Exchange Commission SEC and the Commodity Futures Trading Commission CFTC. The Commodity Futures Modernization Act of , which was also responsible for the Enron loophole , [6] specifically stated that CDSs are neither futures nor securities and so are outside the remit of the SEC and CFTC. At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in connection with its lending activities.

Banks also saw an opportunity to free up regulatory capital. The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw trading opportunities in credit default swaps. By , investors as speculators, rather than banks as hedgers, dominated the market. Although speculators fueled the exponential growth, other factors also played a part.

An extended market could not emerge until , when ISDA standardized the documentation for credit default swaps. Explosive growth was not without operational headaches. On September 15, , the New York Fed summoned 14 banks to its offices.

Billions of dollars of CDS were traded daily but the record keeping was more than two weeks behind. Since default is a relatively rare occurrence historically around 0. Thus, although the above figures for outstanding notionals are very large, in the absence of default the net cash flows are only a small fraction of this total: The market for Credit Default Swaps attracted considerable concern from regulators after a number of large scale incidents in , starting with the collapse of Bear Stearns.

In the days and weeks leading up to Bear's collapse, the bank's CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital, which eventually led to its forced sale to JP Morgan in March.

An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear's collapse; i. This difference is due to the process of 'netting'. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral, so that their losses and gains after big events offset each other.

The CDS on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in that triggered payouts. In there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter OTC. This led to recent calls for the market to open up in terms of transparency and regulation.

Intercontinental's clearing houses guarantee every transaction between buyer and seller providing a much-needed safety net reducing the impact of a default by spreading the risk. ICE collects on every trade. Terhune Bloomberg Business Week Litan, cautioned however, "valuable pricing data will not be fully reported, leaving ICE's institutional partners with a huge informational advantage over other traders.

He calls ICE Trust "a derivatives dealers' club" in which members make money at the expense of nonmembers Terhune citing Litan in Bloomberg Business Week In the U. Securities and Exchange Commission granted an exemption for Intercontinental Exchange to begin guaranteeing credit-default swaps.

The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. The early months of saw several fundamental changes to the way CDSs operate, resulting from concerns over the instruments' safety after the events of the previous year.

The Latest Bill Gross Trade: Shorting High-Yield Corporate Credit Spreads | Seeking Alpha

According to Deutsche Bank managing director Athanassios Diplas "the industry pushed through 10 years worth of changes in just a few months". By late processes had been introduced allowing CDSs that offset each other to be cancelled.

Additionally there are some globally agreed standards falling into place in March , administered by International Swaps and Derivatives Association ISDA. Two of the key changes are:. The introduction of central clearing houses, one for the US and one for Europe.

A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear. Speaking before the changes went live, Sivan Mahadevan, a derivatives analyst at Morgan Stanley, [73] one of the backers for IntercontinentalExchange's subsidiary, ICE Trust in New York, launched in , claimed that.

A key competitor also interested in entering the CDS clearing sector is CME Group. In Europe, CDS Index clearing was launched by IntercontinentalExchange's European subsidiary ICE Clear Europe on July 31, It launched Single Name clearing in Dec By the end of , banks had reclaimed much of their market share; hedge funds had largely retreated from the market after the crises. The SEC's approval for ICE Futures' request to be exempted from rules that would prevent it clearing CDSs was the third government action granted to Intercontinental in one week.

On March 3, its proposed acquisition of Clearing Corp. On March 5, , the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to begin clearing.

Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH. Only the NYSE effort is available now for clearing after starting on Dec. Intercontinental said in the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements.

A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. In April , hedge fund insiders became aware that the market in credit default swaps was possibly being affected by the activities of Bruno Iksil , a trader for J.

Heavy opposing bets to his positions are known to have been made by traders, including another branch of J. Morgan, who purchased the derivatives offered by J. Morgan in such high volume. The disclosure, which resulted in headlines in the media, did not disclose the exact nature of the trading involved, which remains in progress. The item traded, possibly related to CDX IG 9, an index based on the default risk of major U.

A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association. The period over which default protection extends is defined by the contract effective date and scheduled termination date.

The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract , and for performing various calculation and administrative functions in connection with the transaction.

By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice.

Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare. CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer.

Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high-yield corporate reference entities typically do not.

Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions other than Rule A , that it be of a standard currency and that it not be subject to some contingency before becoming due.

The premium payments are generally quarterly, with maturity dates and likewise premium payment dates falling on March 20, June 20, September 20, and December Due to the proximity to the IMM dates , which fall on the third Wednesday of these months, these CDS maturity dates are also referred to as "IMM dates".

The European sovereign debt crisis resulted from a combination of complex factors, including the globalisation of finance ; easy credit conditions during the — period that encouraged high-risk lending and borrowing practices; the — global financial crisis ; international trade imbalances; real-estate bubbles that have since burst; the — global recession ; fiscal policy choices related to government revenues and expenses; and approaches used by nations to bail out troubled banking industries and private bondholders, assuming private debt burdens or socialising losses.

The Credit default swap market also reveals the beginning of the sovereign crisis. Since December 1, the European Parliament has banned naked Credit default swap CDS on the debt for sovereign nations. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings i.

During the Greek sovereign debt crisis, one important issue was whether the restructuring would trigger Credit default swap CDS payments. European Central Bank and the International Monetary Fund negotiators avoided these triggers as they could have jeopardized the stability of major European banks who had been protection writers.

An alternative could have been to create new CDS which clearly would pay in the event of debt restructuring. The market would have paid the spread between these and old potentially more ambiguous CDS. This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code.

In particular, concerns arising out of Conseco 's restructuring in led to the credit event's removal from North American high yield trades. As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled. The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations.

This is because many parties made CDS contracts for speculative purposes, without actually owning any debt that they wanted to insure against default.

The trade confirmation produced when a CDS is traded states whether the contract is to be physically or cash settled. When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction also known as a credit-fixing event may be held to facilitate settlement of a large number of contracts at once, at a fixed cash settlement price.

During the auction process participating dealers e. A second stage Dutch auction is held following the publication of the initial midpoint of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans.

Where to get price data on Credit Default Swaps? - Quantitative Finance Stack Exchange

The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association ISDA , who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington Mutual.

Below is a list of the auctions that have been held since There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to herein as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

The second model, proposed by Darrell Duffie , but also by John Hull and Alan White , uses a no-arbitrage approach. Under the probability model, a credit default swap is priced using a model that takes four inputs; this is similar to the rNPV risk-adjusted NPV model used in drug development:.

If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end:.

To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.

The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time. To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give. In the 'no-arbitrage' model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage.

Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying assumptions such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default , which may invalidate the no-arbitrage assumption.

However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of , and the swap spread is 70 basis points, then a CDS contract should trade at However, there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor.

The difference between the theoretical model and the actual price of a credit default swap is known as the basis. Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency.

Furthermore, there have been claims that CDSs exacerbated the global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG. In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome.

However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.

Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the General Motors Chapter 11 reorganization , because certain bondholders might benefit from the credit event of a GM bankruptcy due to their holding of CDSs.

Critics speculate that these creditors had an incentive to push for the company to enter bankruptcy protection. Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, reducing the net cashflows on the days after the auction.

Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis; that CDS contracts have been acting to distribute risk just as was intended; and that it is not CDSs themselves that need further regulation but the parties who trade them.

Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction.

In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man or sometimes, so it seems, madmen. To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one's counterparty.

The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection.

The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. During the financial crisis , counterparties became subject to a risk of default, amplified with the involvement of Lehman Brothers and AIG in a very large number of CDS transactions.

This is an example of systemic risk , risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk. For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in and decided to hedge their exposure by buying CDS protection from Lehman Brothers.

After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman Brothers and AIG's inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain of CDS transactions between financial institutions.

Chains of CDS transactions can arise from a practice known as "netting". However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C.

The problem lies if one of the companies in the chain fails, creating a " domino effect " of losses. For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company.

Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B. As described above , the establishment of a central exchange or clearing house for CDS trades would help to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers. S federal income tax treatment of CDS is uncertain Nirenberg and Kopp There is a risk of having CDS recharacterized as different types of financial instruments because they resemble put options and credit guarantees.

If a CDS is a notional principal contract, pre-default periodic and nonperiodic payments on the swap are deductible and included in ordinary income. The thrust of this criticism is that Naked CDS are indistinguishable from gambling wagers, and thus give rise in all instances to ordinary income, including to hedge fund managers on their so-called carried interests, [] and that the IRS exceeded its authority with the proposed regulations.

The accounting treatment of CDS used for hedging may not parallel the economic effects and instead, increase volatility.

For example, GAAP generally require that CDS be reported on a mark to market basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce considerable volatility into the income statement and balance sheet as the CDS changes value over its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS.

One can try to account for the CDS as a hedge under FASB [] but in practice that can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular CDS that was bought.

A new type of default swap is the "loan only" credit default swap LCDS. This is conceptually very similar to a standard CDS, but unlike "vanilla" CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of "Bond or Loan".

Also, as of May 22, , for the most widely traded LCDS form, which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same that has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any additional steps following a credit event i.

On October 23, , the first ever LCDS auction was held for Movie Gallery. Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name. From Wikipedia, the free encyclopedia.

Buyer purchased a CDS at time t 0 and makes regular premium payments at times t 1 , t 2 , t 3 , and t 4. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t 5 , t 6 and so on until the end of the contract at time t n. However, if the associated credit instrument suffered a credit event at t 5 , then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller. Causes of the European sovereign-debt crisis.

Why do they exist? Retrieved January 5, International Swaps and Derivatives Association ISDA. Retrieved April 8, Retrieved March 12, Systemic Risks and Policy Options" PDF. Retrieved April 25, Heading towards a more stable system" PDF. Retrieved April 15, Securities and Exchange Commission. Retrieved April 2, University of Cincinnati Law Review. DTCC Policy for Releasing CDS Data to Global Regulators". Retrieved April 22, Making Fraudulent Transfer Law More Predictable, in Handbook on Corporate Bankruptcy.

Economic Review FRB Atlanta , Fourth Quarter Retrieved 13 January Retrieved March 26, A Primer on Credit Default Swaps". Retrieved March 31, Harrington July 24, What are they good for? Retrieved April 24, Derivatives and Alternative Investments. Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions".

Senate Committee on Banking, Housing, and Urban Affairs. Retrieved March 17, A Brief Insurance Primer". Retrieved November 3, If the fund manager acts as the protection seller under a CDS, there is some risk of breach of insurance regulations for the manager However, if certain requirements are met, credit derivatives do not qualify as an agreement of non-life insurance because such an arrangement would in those circumstances not contain all the elements necessary to qualify it as such.

Retrieved April 3, Archived from the original PDF on May 27, Retrieved April 20, Bank for International Settlements. Retrieved July 2, Retrieved April 23, OCC's Quarterly Report on Bank Derivatives Activities".

Office of the Comptroller of the Currency. Fabozzi May 5, Structures and Analysis, 2nd Edition. Retrieved April 27, A Guide for Policy Makers, Citizens and Other Interested Parties" PDF. The Looting of America: How Wall Street's Game of Fantasy Finance Destroyed Our Jobs, Our Pensions, and Prosperity, and What We Can Do About It. One Way to Stop Bear Raids". Retrieved March 15, Guidelines for National Banks" txt. Retrieved 8 April Archived from the original PDF on June 26, Chatiras, Manolis, and Barsendu Mukherjee.

Investigation using Stocks and High Yield Bonds. Center for International Securities and Derivatives Markets, Isenberg School of Management, University of Massachusetts, Amherst, Journal of Applied Corporate Finance. How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe. Retrieved April 7, Invention of Credit Derivatives". What are credit default swaps? The lack of standardized documentation for credit swaps, in fact, could become a major brake on market expansion.

IMF Policy Discussion Paper. Retrieved August 27, Retrieved April 9, Financial Risk Outlook The Financial Services Authority. Retrieved March 27, Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions Christopher Cox, September 23, ". Retrieved April 30, The Sultan of Swaps". Retrieved February 15, Litan April 7, Archived from the original PDF on May 28, The exchange will begin clearing credit-default swaps next week".

Retrieved Dec 15, The Wall Street Journal.

SwapsInfo

The New York Times. Retrieved May 16, Retrieved Nov 26, Fed to hold CDS clearance talks". Retrieved March 1, Retrieved July 14, Retrieved November 6, Annual Report " PDF. Retrieved September 21, Retrieved December 21, Retrieved 4 Monolines faces litigious and costly endgame , Aug , Louise Bowman, euromoney.

All things Considered, National Public Radio. Tax Treatment of Total Return Swaps, Default Swaps, and Credit-Linked Notes". Nirenberg November 26, Retrieved July 28, Brandes July 21, REG, IRB Oct.

Proposed Rules Mistakenly Classify Section Contracts, I.

Witnesses Say, DAILY TAX REP. Legalized Gambling, 8 U. Credit spread Debit spread Exercise Expiration Moneyness Open interest Pin risk Risk-free interest rate Strike price the Greeks Volatility. Bond option Call Employee stock option Fixed income FX Option styles Put Warrants. Asian Barrier Basket Binary Chooser Cliquet Commodore Compound Forward start Interest rate Lookback Mountain range Rainbow Swaption.

Collar Covered call Fence Iron butterfly Iron condor Straddle Strangle Protective put Risk reversal. Back Bear Box Bull Butterfly Calendar Diagonal Intermarket Ratio Vertical. Binomial Black Black—Scholes model Finite difference Garman-Kohlhagen Margrabe's formula Put—call parity Simulation Real options valuation Trinomial Vanna—Volga pricing.

Amortising Asset Basis Conditional variance Constant maturity Correlation Credit default Currency Dividend Equity Forex Inflation Interest rate Overnight indexed Total return Variance Volatility Year-on-Year Inflation-Indexed Zero-Coupon Inflation-Indexed. Contango Currency future Dividend future Forward market Forward price Forwards pricing Forward rate Futures pricing Interest rate future Margin Normal backwardation Single-stock futures Slippage Stock market index future.

Energy derivative Freight derivative Inflation derivative Property derivative Weather derivative. Collateralized debt obligation CDO Constant proportion portfolio insurance Contract for difference Credit-linked note CLN Credit default option Credit derivative Equity-linked note ELN Equity derivative Foreign exchange derivative Fund derivative Interest rate derivative Mortgage-backed security Power reverse dual-currency note PRDC.

Consumer debt Corporate debt Government debt Great Recession Municipal debt Tax policy.

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A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. Trading will be much easier We also feel like over time we'll see the creation of different types of products Mahadevan cited in Bloomberg For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its exemptive requests.

Masonite [1] - LCDS. Sanitec [2] - 1st Lien. Sanitec [3] - 2nd Lien. British Vita [4] - 1st Lien. British Vita [5] - 2nd Lien. Look up credit default swap in Wiktionary, the free dictionary. Terms Credit spread Debit spread Exercise Expiration Moneyness Open interest Pin risk Risk-free interest rate Strike price the Greeks Volatility.