SHAHEED ZULFIQAR ALI BHUTTO INSTITUTE OF SCIENCE & TECHNOLOGY KARACHI CAMPUS

CORPORATE FINANCE M. ALI SAEED

CREDIT DEFAULT SWAPS (CDS)

ABDUL JABBAR (1125101) WAJID ALI SHAH (0928139) INTIZAR ALI SHAH (0936155) HUSSAINI AOUN ABBAS (1135287)

Contents
Introduction ....................................................................................................... 3

Prospects & Constraints ..................................................................................... 5 PROS ............................................................................................................... 5 CONS............................................................................................................... 6

Analytical Portion............................................................................................... 6

Reference .......................................................................................................... 9

Introduction
Credit Default Swap is a derivative based on a bond or basket of bonds as the underlying assets. The CDS is used to transfer credit risk to another party. In simple words, a CDS is a privately negotiated bilateral contract in which one Party A, usually known as the protection buyer, pays a fee or premium to another Party B, generally referred to as the protection seller, to protect himself against the loss that may be incurred on his exposure to an individual loan or bond as a result of an unforeseen development. This development is usually known as a "Credit Event" refers to restructuring, failure to pay, bankruptcy, repudiation and obligation acceleration. In other words it indicates that the borrower known as Party C, on which the CDS contract has been written is unable to pay its debt. In general CDS can be used to hedge credit risk, to take on credit risk and leverage by providing credit protection to others. Following Figure gives a Generic Flow of Credit Default Swaps.

o o

One party sells risk and the counterparty buys that risk. The seller of credit risk - who also tends to own the underlying credit asset - pays a periodic fee to the risk buyer.

In return, the risk buyer agrees to pay the seller a set amount if there is a default.

In Credit Default Swaps, The protection seller receives a periodic premium from the Protection Buyer in exchange for a contingent payment if there is a Credit Event of the Reference Entity. The contingent payment is determined based on pre-specified settlement terms. In other words, the protection seller agrees to compensate the protection buyer if a

default event occurs before maturity of the contract. If there is no default event before maturity, the protection seller pays nothing. The protection seller charges a fee for the protection. CDS contracts have been compared with Insurance because just like Insurance contracts, the buyer has to pay a premium to the seller and the seller has to cover losses in case of any credit event occurs. However, there are number of differences between both concept and some of them are discussed as following: o o Insurance policies are operated under the regulated entity whereas CDS contracts are free from regulatory authority. In the United States CDS contracts are generally subject to mark-to-market accounting, financial statements volatility that would not be present in an Insurance contract. o Insurance contract provides a protection against future losses actually suffered by the policy holders, whereas the CDS provides an equal payout to all holders (calculated using market-wide method). Credit Default Swaps are used to reduce exposure to an adverse turn in credit market conditions, to enhance performance of a basket of bonds or to trade on events that may happen to bonds that the buyer of protection does not own. For every buyer there has to be a seller of protection who will want a premium that reflects the risk of Insurance. The major end-users of credit default swaps are banks, hedge funds and Insurance companies. A Credit Default Swaps may be used by: o o the eligible protection buyers, for buying protection on specified loans and advances, or investments where the protection buyer has a credit risk exposure. the eligible protection sellers, for selling protection on specified loans and advances, or investments on which the protection buyer has a credit risk exposure and generate a premium on that transaction. The importance or significance of Credit Default Swaps can be explained in terms of Liquidity, Risk Management, Risk Separation & Reliable Funding Source. o o Liquidity: The Credit Default Swaps add depth to the secondary markets of underlying credit instruments which may not be liquid for variety of reasons. Risk Management: Credit derivatives not only make risk management more efficient but this makes it more flexible by allocating credit risk to most of the efficient managers.

o o

Risk Separation: Credit derivatives allow for separation of credit risk of the referenced assets. Reliable Funding Source: Credit derivatives help exploiting a funding advantage and similarly avoiding a funding disadvantage.

Prospects & Constraints

PROS

Neutralize Credit Risk

CREDIT DEFAULT SWAP

Pros
Signaling Creditworthiness Transfer Credit Risk

Neutralize Credit Risk Credit Default Swaps neutralize credit risk by giving flexibility to the asset managers to hedge and optimize their risk profile. Risky Bonds + Credit Default Swap Asset without Credit Risk

Signaling Credit Worthiness Signaling Credit Worthiness to other market participants.

Transfer Credit Risk In CDS contracts, one party transfer their credit risk to another party on specified agreed terms.

CONS

Lack of Regulatory Authority

CREDIT DEFAULT SWAP

Cons
Complex Distribution of Risk
Probability to Default

Lack of Regulatory Authority A Credit Default Swap contracts are privately negotiated derivatives and have no proper regulations so this is ultimately leads market with no transparency.

Probability to Default Pricing assumes a particular probability that default will occur as if it is misgauged, so the CDS seller must have losses.

Complex Distribution of Risk The CDS contracts have been perceived as the main root of all evil in the credit market because of its complex distribution of risk.

Analytical Portion
Since its inception early in the 1990s, the credit default swap market has evolved into a major component of the capital market. Lack of regulation makes it difficult to assess the growth of this market class. This growth may reflect the increasing appeal of CDS for a growing opportunities in the financial sector.

Some of its major end-users (banks, hedge funds and Insurance companies) have experienced severe losses during the past financial crisis. For example: the world largest Insurance company - AIG, was brought to the brink of collapse due to its use of CDS.

Credit Default Swaps (CDS) have been criticized as being highly complex instruments that are difficult to leave. Some of financial expert call CDS as financial weapons of mass destruction. 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, CDS and other such debt-related derivatives have been blamed for making 2007 credit crisis a lot more severe than it should have been and have led to the failure of institutions. Experts claims that CDSs exacerbated the 2007 global financial crisis 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. As the risk of defaults rose, the cost of CDS protection rose. Investors (mostly Investment bankers) could arbitrage between the lower and higher risk CDSs and generate large income streams with what was perceived to be minimal risk. In 2007, the notional value (face value of underlying assets) of CDS had reached $62 trillion which is more than the combined Gross Domestic Product of the entire world $54 trillion. CDS generated large profits for the companies involved until the default rate, particularly on subprime mortgages, and the

number of bankruptcy began to rise. The leverage that generated outsized profits began to generate outsized losses. Defaults and declines in values of such derivatives like CDS and CDOs put big holes in balance sheet of financial institutions. By October 2008, the exposure became too great for companies such as AIG, Lehman Brothers, Freddie Mac etc.

Reference
Moorad Choudhry. 2003. "Credit Default Swaps and the Synthetic Collateralized Debt Obligations", Bloomberg Seminar Janet Tavokali "Introduction to Credit Derivatives - Credit Default Swaps", Tavokali Structured Finance,Inc Ronald N. Anderson. 2010. "Credit Default Swaps: What are the social benefits and cost?", London School of Economics Tim Backshell. 2004. "Improving Performance with Credit Default Swaps", Research Insights Rene M. Stulz. 2010. "Credit Default Swaps and the Credit Crisis", Journal of Economics Perspective www.google.com www.wikipedia.com