A Look at Credit Default Swaps and Their Impact on the European Debt Crisis

Article excerpt

Credit default swaps (CDS) are financial derivative contracts that are conceptually similar to insurance contracts. A CDS purchaser (the insured) pays fees to the seller (the insurer) and is compensated on the occurrence of a specified credit event. Typically, such a credit event is the default or bankruptcy of a corporate or sovereign borrower (also known as the reference entity). The difference between traditional insurance and CDS is that CDS purchasers need not have any financial stake in the reference entity. Therefore, buying a CDS can be analogous to an individual insuring his neighbor's car and getting paid if the neighbor is involved in a car accident. Just like in an insurance contract, the individual pays a periodic premium to a CDS seller in return for compensation should the credit event (accident) occur. Importantly, the individual is compensated even though he may have no financial stake in his neighbor's car.

The Origins of CDS

CDS were introduced in the mid-1990s as a means to hedge risk against a credit event. Initially, commercial banks used CDS to hedge the credit risk associated with large corporate loans. The attractiveness of a CDS contract emerges from the fact that these are made over the counter and generally adhere to the International Swaps and Derivatives Association's (ISDA) master agreement.1 As a result, they allow transacting parties to avoid regulatory requirements imposed by more-formal insurance arrangements. With the evolution of this market, CDS contracts were written on a variety of sovereign, corporate and municipal bonds, as well as on more-complex financial instruments, such as mortgage-backed securities and collateralized debt obligations. Unlike with insurance arrangements, sellers of CDS were not subject to significant regulation and were not required to hold reserves against CDS in case of default. It is widely believed that this exacerbated the recent financial crisis by allowing financial firms to sell insurance on various securities backed by residential mortgages and other assets.

How Do They Work?

Typically, the CDS requires that the purchaser pay a spread (fee) quoted in percentage (basis points) of the amount insured. For example, the protection buyer of a CDS contract of an insured amount of $20 million and a premium of 100 basis points pays a (quarterly) premium of $50,000 to the CDS seller.2 The premiums continue until the contract expires or the credit event occurs. Higher premiums indicate a greater likelihood of the credit event.

Settlement occurs in one of two ways: physical or cash. Physical settlement requires that the buyer of the protection deliver the insured bond to the seller, who pays the buyer the face value of the loan. The occurrence of the credit event would generally imply that the asset is trading well below par. Conversely, in a cash settlement agreement, the seller of the CDS simply pays the difference between the par value and the market price of the obligation of the reference entity.3 Suppose that in our example, the recovery rate on the obligation of the reference entity is 40 percent on the occurrence of the credit event; then, the protection seller makes a one-time cash payment of $12 million to the protection buyer as shown in the diagram at the top of the next column.

CDS Spreads and the European Debt Crisis

CDS spreads are an important metric of default risk-a higher spread on the CDS implies a greater risk of default by the reference entity. This feature can provide useful information as to how financial markets perceive the risk of default on corporate and sovereign debt. To illustrate this phenomenon, we study changes in the CDS spreads on the debt of European nations over the past few years. Figure 1 illustrates spreads on five-year CDS in Europe since 2005. Each series is an equally weighted index of country groupings where data are available-distressed countries in the eurozone (European Union members that use the euro as their currency), other countries in the eurozone, Western European countries that do not use the euro as currency and Eastern European countries that do not use the euro as currency. …