An understanding of credit default swaps is essential in order for you to understand the workings of credit-linked notes or structured products.
In this post, I will give a brief introduction to credit default swaps.
But first, we need to know what a bond is. A bond is simply a debt obligation of a company.
For example, if you use $100,000 to buy a 5-year bond from SPH, you are essentially lending $100,000 to SPH. In return for the loan, SPH agrees to pay you a coupon (or interest rate) of say 4.5% p.a.
In the event that SPH goes bankrupt, you will lose a huge part of your principal. The amount you get back will depend on the recovery rate. If the recovery rate is 40%, you will get back $40,000 of your capital.
To mitigate the risk of a SPH failure on your SPH bond, you can buy a credit default swap (CDS) on SPH. This is like buying an insurance plan that pays you if SPH defaults on your loan. The cost of this insurance premium might be about a couple of percentage points every year but will depend on a few factors including:
- Credit rating of SPH
- Market conditions
- Government risk free interest rate
Using our earlier example of a SPH failure, the seller of the CDS (which acts as the insurance company), will have to pay you $60,000, which is the amount you lost based on a recovery rate of 40%.
If SPH does not default on their bond for the duration of the CDS, the CDS seller happily pockets the premium.
The thing about CDS is that anyone can purchase it without the need for owning the underlying debt. If I feel that SPH is going to fail soon, I can buy a CDS on their default even though I might not hold any SPH bonds.
Conversely, almost anyone might sell a CDS without the need for showing that they can handle the payouts in the event of a default.
In the search for greater yield, this “free for all” mentality in a largely unregulated environment has led to an explosion in the CDS market. So much so until no one really knows what the size of everyone’s else CDS exposure is. And whether they can pay the liabilities in the event of defaults. Furthermore, it is clear now that some institutions have underpriced the CDS that they sold.
This is also the instrument that single-handedly bought down AIG.
And when someone talks about unwinding a CDS position, it simply means cancelling this “insurance contract”. There’s a cost (or profit) to this of course. This will depend on the market rate of the CDS at the point when the position is unwinded.
Let’s say you sold CDS for SPH at a 2% premium. If the current CDS rate for SPH is at 1%, you can buy your own SPH CDS at 1% and transfer away the risk of SPH defaulting (assuming no counter-party risk). Then, you would have made 1%. However, if the market rate for a SPH CDS is at 4%, you would have lost 2% in order to transfer this risk away.
The mathematics would be similar for the cancellation of any credit default swap between the swap parties.
The cost of CDS has increased significantly since the collapse of Lehman Brothers. Thus, most unwinding of CDS positions would have resulted in losses for the original seller.