Credit Default Swaps (CDS) and Credit Derivatives › Summary

Credit default swaps transformed credit risk from an illiquid, embedded feature of loans and bonds into a tradeable instrument. The key concepts from this chapter include:

CDS Structure: A CDS involves a protection buyer paying periodic premiums to a protection seller in exchange for compensation if the reference entity experiences a credit event. The premium leg consists of spread payments contingent on survival, while the protection leg provides a payment equal to loss given default.

Pricing Framework: The fair CDS spread equates the present value of expected premiums with the present value of expected protection payments. For a constant hazard rate $\lambda$ and recovery rate $R$, the spread approximates $s \approx \lambda(1-R)$. The exact formula accounts for discounting and the timing of cash flows using survival probabilities and discount factors.

Implied Default Probabilities: CDS spreads provide market-based estimates of credit risk. A spread of 100 bps with 40% recovery implies roughly a 1.67% annual default probability, or about 8% cumulative probability over five years.

Applications: CDS serve to hedge credit exposure in loan portfolios, speculate on credit quality changes, and execute arbitrage strategies exploiting the CDS-bond basis.

Risks: Counterparty risk, wrong-way risk, liquidity risk, and model risk all present challenges. The 2008 financial crisis revealed how these risks can materialize simultaneously during periods of systemic stress.

The next chapter extends these concepts to structured credit products, where portfolios of credit risk are tranched and distributed to different investor classes based on their risk appetite.