Friday, February 12, 2010

The Credit Default Swap (CDS) Market

The Credit Default Swap (CDS) market has been in the news recently, as Greece goes through the throes of imminent or not-so-imminent default. I thought it would make sense to put down my thoughts on the market:

a. What is a CDS?
A CDS allows you to buy insurance against default by a specific entity - government or corporate. Consider, for instance, the 5-year CDS against Brazilian default. On February 11, 2010, it would have cost you 137 basis points to buy this swap on the CDS market. In practical terms, if you had $ 100 million in $ denominated 5-year bonds issued by the Brazilian government, you would pay $1.37 million each year for the next 5 years for protection against default If the Brazilian government defaulted during the period, you would receive $ 100 million.

There are CDS available on more than 50 governments, dozens of quasi-government instiutions and many large corporations. You can, in effect, make your investment in any of these institutions close to riskfree by buying CDS on any of them.

One feature of the CDS market that needs attention is that there is the possibility of counter party risk on both sides. In effect, both the buyer and the seller may default. Thus, in the 5-year Brazil CDS example, the buyer may not be able to deliver $1.37 million a year for the next 5 years and the seller may not be in a position to deliver $ 100 million, in the event of default.

b. History and growth of the CDS market
The CDS market was devised by a group of bankers at J.P. Morgan as a measure to protect the bank and clients against potential default in the late 1990s. Initially, the market was a very small one, used by investors to to hedge default risk in large positions. In the last decade, the market exploded as both buyers and sellers flocked into it. By 2008, the dollar value of securities covered by Credit Default Swaps exceeded $ 50 trillion and in fact was larger than the actual bond market. Put another way, people were buying insurance against default risk in securities that did not even exist.

c. Why would anyone buy a CDS?
The answer may seem obvious. Investors will buy a CDS to protect an open position that they have in a bond with default risk. That facile answer can be challenged with an obvious riposte: if you want to take no risk, why not just buy a default-free investment in the first place. Clearly, though, the sheer volume of trading suggests that hedging is only part of the story. The other reason for buying a CDS is because you expect the default spread in an entity to widen in the near future. Thus, an investor who expects Brazil's default risk to increase in the future may buy a 5-year CDS at 137 basis points and turn around and sell it for a much higher price later, if he is right.

In fact, one critique of the CDS market is that it is less about hedging and more about speculating. The Greek and Portuguese governments have complained that the CDS markets have deepened their woes:
http://online.wsj.com/article/SB40001424052748703382904575058881703896378.html?mod=WSJ_Markets_section_Heard

d. Why would anyone sell a CDS?
Again, there are two reasons. One is to operate as a broker and make money of transaction volume. If this is the rationale, you would hedge your exposure to risk by both buying and selling CDS and keeping your net exposure close to zero. The other is to speculate. If you expect the default risk in an entity to narrow quickly, you could sell the CDS at a high price and cover at a lower price.

While banks, investment banks and hedge funds are the biggest sellers of CDS, the seller does not have to be a regulated entity though the major sellers are subject to bank capitalization requirements. There is the very real danger that an entity may be tempted to sell CDS to collect cash now and worry about the potential liabilities later (AIG and Lehman come to mind...)

e. What information is in a CDS spread (and changes in it)?
The price on a CDS market is a function of demand and supply. For better or worse, it gives you a measure of what the market thinks about the default risk in an entity at a point in time. Note that this is true, whether investors are hedgers or speculators.

The overlay of counter-party risk affects the prices of CDS. This is one reason why the CDS on even default-free entities will trade at non-zero prices. When perceptions of counter-party risk rise across the board, as they did after the Lehman default, the prices of all credit default swaps will go up.

f. How can we use that information in corporate finance/valuation?
There are at least two places where the CDS market can be put to good use:
a. Country equity risk premiums: The equity risk premium for a risky emerging market should be greater than the equity risk premium for a developed market. One way to compute the additional risk premium is to compute a default spread for the riskier market and the CDS price provides a good starting (or even ending) point. In the Brazil example above, this would translate into using an equity risk premium for Brazil that is at least 1.37% (the CDS price) higher than the premium for the US. In more sophisticated versions of this approach, the 1.37% will be modified to account for additional equity market risk.

b. Cost of debt: The cost of debt for a firm can be obtained by adding a default spread for the firm to a riskfree rate. While this default spread can be difficult to obtain for many companies, we can use the CDS spread for a company (if one exists) to the riskfree rate to get to a pre-tax cost of debt.

In closing, there is useful informaton in the CDS market that we ignore at our own peril, when doing financial analyses and valuation. While there is substantial volatility in the market, the prices in the market allow us to get a sense of what investors think about default risk in entities and the price they would charge for bearing or eliminating that default risk. While it does open the door to those betting on default risk changes, it makes no sense to shoot the messenger and to ignore the message. The default risk problems faced by the Greek, Spanish and Portuguese governments are of their own doing and have been a decade in the making. Blaming the CDS market for these problems makes no sense!

21 comments:

Guru said...

Professor

That was an enlightening post on the concept of CDS and how it operates. What makes an entity qualified to originally sell the risk? (capital adequacy etc?)

Shivagurunathan

bits said...
This comment has been removed by the author.
bits said...

Thanks for the post Sir.

I have a query. I dont understand the reason to sell CDS. Just in case a country/corporate defaults, the seller would have huge obligations and in case of unfullfillment, it would trigger an additional round of defaults. The buyer would be at even greter losses.
Also, unlike insurance, where there is a long statistical history, current scenerio of possiblity of Sovergin defaults is a result of a structural phenominom which builds over decades.
Is there anothe bubble into making, ready to take down financial institutes surviving post Sub-prime crisis?

Nilesh

Fabian said...

very interesting comment. but i believe that the cds market is dominated by asymmetric information. the seller of a cds either knows the financial situation of the reference entity better than the buyer, or he is able to hedge its cds-sellside risk cheaper. because of this asymmetry it does not make sense to trade such instruments on a ccp.

donlsan04 said...

As always, your posts deliver the most important and basic questions that should be made. I have a side question relating to this issue. Can one argue that CDS functioned as a mechanism to shorten the recession period? After the collapse of Drexel Burnham Lambert in the late 80s, high yield bond market lost its attractiveness and volume. Companies with low investment grades were hard to open up the door in the primary market. But, the invention of CDS has made it possible again. The investors in the junk bonds could just simply buy CDS concurrently, without fearing of default. As a result, even when the country was hit with recession, due to the CDS market, the whole economy has shown incredible resilience. The industries or companies that had hard time getting money from the capital markets were now able to get debt funding freely and there were no more prolonged recession. On the flip side though, if there is more restrictions in this market and the volume dries up, can one argue that the high-yield market will shrink again and there will be a following prolonged recession?

Sunny Sabharwal said...

As simple yet informative as it could be.

Would request you to write something on active portfolio management and stock picking (especially for the Indian market).

Regards,
Sunny

Mahesh said...
This comment has been removed by the author.
Mahesh Sethuraman said...

Hi,

I have a doubt abt the usage of CDS spread in calculating country equity risk premium. Isn't it a little inappropriate to build debt related info into equity premium?

I did read your paper on "Risk premium" and your article in QFinance on this, which gave me greater clarity. But somehow I still feel that relative stdev method (however much lack of adequate data in emerging economies is a prob) is more apt than using debt default spreads (even after adjusting for the relative stdev btw bonds and stocks). Aren't stocks and bonds very different animals. What's a gr8 pick for VCs might be a very bad lending choice for banks - isn't it?

Leonardo von Prellwitz said...

Hi professor,

now that the US Debt is carrying ~5% default chance according to the CDS spreads, how is that going to influence the risk free interest rate calculation?

Thank you,

Aswath Damodaran said...

See my earlier post on riskfree rates.

Aman said...

Sir this was a realy nice post. Especially how you have related the spread of the CDS with the Risk Free Rate and then used it to calculate the risk premium. Thanks for this.

Jaime A said...

Great post about CDS. Two questions.

1) where do you get spreads for CDS? The actual number of 127 bp for Brazil for example.

2) During a class at HKS by Prof. Akash Deep, we used Probabilities of default and loss given default to calculate the price of a CDS, is this not used in the industry to price these instruments?

I also thought the question regarding using debt information to build into risk premium was an interesting one.

Thanks,
Jaime A

Aswath Damodaran said...

The CDS spread has to be related to the risk of default. The CDS spreads are market information. While they may not be reported in the Wall Street Journal or Financial Times, they are out there. I have access to them through a Bloomberg terminal but you should be able to get them anyway.

Aswath Damodaran said...

The CDS spread has to be related to the risk of default. The CDS spreads are market information. While they may not be reported in the Wall Street Journal or Financial Times, they are out there. I have access to them through a Bloomberg terminal but you should be able to get them anyway.

Nishad said...

Aswath ,your exposition of the CDS was clear I used it to explain the concept to a lay person. Good to see a fellow class mate from IIMB put things with such clarity .

Ankit said...

Dear Sir.

2 Questions ..

1. CDS has been operational for so many years , what do you think was the biggest reason for the current crisis in CDS markets ..

2. Lot of underdeveloped nations rather markets have CDS markets too , do you think there should be a global authority which should certify the markets to launch certain products like CDS ? I believe if there markets are not developed enogh to handle complex products like exoic options or CDS they should not be allowed to market them ..

Been there , done that said...

The fact that these instruments exist is exposes the precarious nature of the ability to finance public debt. We are on the precipice of default all over the world , unless all nations collectively print more and more money. This is the liquidity trap we shall soon all experience. AIG was just the messenger.

Guru said...

BTDT!

Print more currency? Thats Economic Blasphemy! Ideal case of remedy being worse than the disease!

Guru

HundReD said...

Hello SIR, Please answer this QUERY.

the question is in regards for a person who is buying a CDS for hedging, and not for speculating. Bonds have a specific maturity date, and before that the question of repayment does not arise in the first place. So why will I (as an investor) will like to cover my position now, when i can do the same thing in year 5, when the bond is maturing? why will i keep paying premiums for 5 years, when i can have the same benefits if i buy a CDS in year 5 also?

Thanks. (A BIG FAN OF YOU)

krish said...

hello sir. i am gopal
thanks a lot for information on CDS. this is the first time i am commenting on a blog because of the way u presented and it was simple. keep the good work for students like me.
thanking you from my heart.
my id: krisbuzztech@gmail.com

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