CDS: How to Make Money off a Default

Lately the credibility of countries and companies is defined not only by the rating agencies but by the market itself. The new invention that made this possible was made by Blythe Masters, a mathematician and a Cambridge graduate, working for J.P.Morgan Chase Bank. The name of the invention is the credit-default swap (CDS) and the first CDS agreement was signed in 1997 to manage risks.     

A swap is a contract according to which one side agrees to pay (usually every three months) the other side a certain amount while the other side agrees to compensate in case of a default of, for instance, government bonds. Usually the swap contract is signed for the amount of $10-20 M (it guarantees that in case if a country’s government bonds for the mentioned amount default, the purchaser of the bonds will be reimbursed for the purchase). The usual term of a swap contract is 5 years. The price or the swap spread published in the business media is the borrower’s bonds credit risk indicator. The price consists of the annual amount paid by the swap purchaser for default protection and is usually measured in base points that are easily converted into percentage (1 base point – 0.01%). The payments are made until the expiration of the contract.

Let’s give an example. A bank buys $10 M of government bonds of a European country on the market. To protect itself from the possible default of the borrowing country, the bank purchases CDS with the $10 M of nominal amount of the credit obligation. Let’s suppose that the CDS are traded at 300 base points (or 3%). In this case the bank pays the swap seller $10 M x 3%=$300,000 USD annually (usually in quarterly payments) as an “insurance premium” against the default possibility. In the end, if default is not announced the CDS purchaser will get lower returns on investments as he/she will bear losses for the swap. If the default is announced the swap payments cease and the purchaser receives the amount of loss from the CDS seller.

It is reasonable to assume that the higher the CDS price the higher is the borrower’s default risk. The table below shows the CDS prices for the world countries’ bonds and their dynamics. To have a clear idea, CDS’ of Russia were trading at 760 before default in 1997, those of Lehman Brothers traded at 740 before default.

 

Source:  www.businessinsider.com

 

Disclaimer: This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service. Performance data shown represents past performance. Past performance is no guarantee of future results. No part of this article may be copied, distributed, transmitted or published without the prior written consent of the author.

 

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