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Credit Default Swaps (CDS): Your Insurance against Unwanted Defaults [Part-4]

Dear reader, congrats on reaching to Part-4 of this series. If you’re here, I’m assuming that you must’ve already gone through the Basics of CDS (Part 1 & Part 2) and the Structural Valuation of CDS (Part 3). If not, kindly go through the previous parts before proceeding further for a better understanding.

Black Swans & CDS: A Complicated Relationship

Before going into any mathematics, let us first understand what happens during economic crisis or recession – an average company (in terms of fundamentals) faces a sudden drop in revenues and consequently faces difficulties meeting its financial obligations. Banks & lending institutions anticipate this stress & create additional provisions, also doing enhanced evaluation before any further lending to any firm. Lack of new funds (working capital loans) enhance the pre-existing stress of the firms & this loop leads to a catastrophic failure, marked by series of bankruptcies.

From/ToAAABBBCCCD
AAA93%4%2%1%
BBB9%66%20%5%
CCC2%30%48%20%
Table 1: Pre-COVID RTM (Dec, 2019) [representative]
From/ToAAABBBCCCD
AAA89%6%4%1%
BBB7%63%22%8%
CCC2%26%44%28%
Table 2: Post-COVID RTM (Mar, 2020) [representative]

As observed in Table 1 & Table 2, the probabilities of lower rated firms (BBB & CCC) defaulting significantly increased (5% to 8% in case of BBB) and (20% to 28%) in case of CCC. Accordingly, we can calculate the probabilities of default & survival of Vodafone as follows:

Pre-COVID Post-COVID
Prob. of DefaultProb. of SurvivalYearProb. of DefaultProb. of Survival
5.00%95.00%18.00%92.00%
7.02%87.98%210.37%81.63%
17.63%70.35%323.00%58.63%
Table 3: Probability Table for Vodafone

Accordingly, the expected Cashflows associated with the Voda-CDS will now be as follows:

YearPremium Outgoing (-ve)PV (outflows)Default Incoming (+ve)PV (inflows)
1-5.000-4.8398.0007.743
2-4.600-4.30310.3689.700
3-4.082-3.68823.00420.784
  
Net -12.830 38.227
  FV of CDS 25.396
Table 4: Tabulation of expected Cashflows from the Voda-CDS contract

Thus, the P&L of the CDS buyer in Part 3 will now look like the following:

CDS P&L (Voda-CDS)
Buy Price13.5
Fair Value at Buy14.079
Fair Value Gains4.3%
Current Fair Value25.396
MTM Gains88.1%
Table 5: Voda-CDS P&L Snapshot

Interpretation:

Thus, due to the additional uncertainty brought about by COVID-19, the CDS value has gone up by 88% within a few months. This was the primary reason why several big insurers went bust due to the soaring CDS prices & payouts in the 2008 crisis. Thus, CDS gains will offset losses due to any impending financial default by a firm & is widely used as a hedge against credit risk. Apart from hedging, CDS is often used as a common speculative instrument due to its potential for delivering staggering returns similar to other derivatives (Futures & Options). This leads us to the next topic – CDS trading strategies.

CDS Trading Strategies:

Similar to conventional derivatives like Futures & Options, there are a few major strategies that CDS traders (mostly hedge funds & banks) employ:

  • Curve Trading: This type of strategy is based on the dynamic nature of Credit spreads. If a CDS trader expects that short-term credit stress will be higher than long-term stress (like the present COVID-19 situation), he/she may simultaneously buy a Short maturity CDS & sell a Long maturity CDS of the same underlying firm.
  • Basis Trading: This strategy is popularly used by lenders who already have an exposure to any debt instrument of a firm. When chances of a firm getting downgraded are high, its bond yields go up as well as its CDS price. CDS Basis traders make profits by the additional increase in CDS price over the loss due to decrease in bond price (increasing yield).
  • Basket Trading: Extremely popular among CDS sellers, this is similar to an insurance company selling policies to multiple clients. In this case, a CDS seller sells CDS similar maturity contracts on 8-10 companies. Even if 1-2 companies default, the seller pays the Default Incoming amounts & pockets the rest of the Premium Outgoing cashflows.
  • Capital Structure Trading: Often analysts or a company’s management declares that it’s going to increase its leverage in the near-term. Such actions make it relatively riskier and is bound to affect its CDS prices. Capital structure traders typically buy a CDS and hedge it with a Call option on the company’s stock or write a Put option as a self-financing trade.

Food for Thought:

  1. You might’ve often heard that Swaps are zero-cost instruments i.e. you don’t have to pay anything while entering into a swap with another party. But as you’ve seen in the Voda-CDS case study, the CDS buyer has to pay some price while buying the CDS. So, does a CDS violate the zero-cost principle of a typical swap?
  2. Derivatives are said to carry high degree of leverage. So how can we calculate the effective leverage associated with a CDS?

Don’t worry. We’ll look into the above questions in the final part (Part 5) of the CDS series. So, let’s put all our doubts regarding CDS to rest.

Sayantan Ghosh

MBA (Finance), FMVA®