Credit Default Swap (CDS) –De Jargonized

With an estimated outstanding gross notional value of $25.5 trillion, CDS market still rules the world of credit market. Come 2007, CDS market was soaring with the total notional amount of outstanding credit default swaps to be around $ 62.2 trillion. Obviously, recent credit crisis and European sovereign debt crisis, along with unfavorable regulatory changes (i.e. ban on naked CDS position in Europe) took toll on CDS market. Did CDS as a credit market instrument lost its charm after 2007? Well, let’s leave that discussion for some other time. Let’s first try to understand what CDS is all about.

What is CDS?
A CDS is an agreement between two counterparties wherein one party buys credit protection from the other, on a reference entity. Essentially the protection ‘seller’ (one party) insures the protection ‘buyer’ (other party) against the possibility of a default by a particular credit in exchange for the payment of a quarterly premium. In basic sense, CDS is default insurance.

What is the period of CDS protection?
CDS contracts typically vary from 1 year to 10 years, but the most common life is 5 years. No wonder, 5Y CDS is also the most liquid one.

How is premium paid on CDS protection?
Premium is paid on quarterly basis and is often quoted in basis points (bps) per annum. The contracts’ value varies with the quality of the credit of credit of the issuer.

What happens when a credit event occurs?
Two things may happen when a credit event occurs: the trade terminates and the protection seller buys deliverable obligation at par (or pays cash settlement).

On what basis CDS is priced?
The pricing of CDS is linked to the credit spread of the issuer on which it is based but may vary depending on macro-economic or market conditions or simply supply/demand. The difference between an issuer’s credit spread (T spd, Z spd) and the price of an equivalent CDS is known as the ‘basis’ and may offer a trading opportunity for traders/investors.

What are the popular CDS indices?
Markit CDX-NAIG
Markit CDX-NAHY
Markit iTraxx Europe
Markit iTraxx Europe Crossover
Markit iTraxx Asia-ex Japan IG