What are Credit Derivatives?
Credit derivatives are another class of derivatives that allow buyers to purchase protection against default by corporations, financial institutions, governments or other entities. The seller of credit derivative agrees to make payments to the buyer if a specified credit event, like default or bankruptcy, occurs. The seller of credit derivative is often referred to by credit derivatives consultants as the protection seller and the buyer is called the protection buyer.
When a corporation decides to issue bonds to fund its activities, it also has to issue bonds that may become worthless. This means that there will be situations when the company can go bankrupt and investors lose their money. Because of this, a corporation must offer higher interest rates on its bonds than companies with better credit ratings in order for it to attract investors. However, there are always risks so these higher interest rates don’t always get paid out by corporations. This type of risk is called credit risk. Some corporations, especially large banks and financial institutions, are perceived as having low credit risks because they are very stable. Investors will be willing to purchase their bonds with lower than market interest rates.
Credit Derivatives and Credit Default Swaps
Credit derivatives allow investors to get exposure to the risk of default without actually purchasing the bond. Suppose an investor is not comfortable with the default risk of a company but still wants to make money off its debt. They can go out and buy credit default swap (CDS) protection on that company’s bonds meaning that they are contracting with another party to make payments if that company’s bonds become worthless. That other party is called the protection seller. To be able to sell this protection, the protection seller must be able to show that their ability to pay is valuable and that they have the money to cover any losses.
One of the reasons why credit default swaps are appealing for investors is because they do not affect a company’s credit rating as much as an actual bond purchase does. The availability of credit derivatives also makes it possible for investors to buy these instruments even if there are not many issues available in their markets. It also allows them to select certain companies and industries without investing a large amount of money at one time. Credit default swap contracts can be short-term, medium-term, or long-term in nature. Most of the time, credit default swaps for medium and long term debt go on the books with a credit rating agency such as Moody’s Investors Service or Standard and Poor’s. Companies that are in this business can also sell CDS protection to other investors without going out and trying to find an investor willing to purchase these types of insurance contracts.
The ability of protection sellers to buy up all the shares of a bond that they want to protect means that they have a significant say over how much stock is available in this market. This is because they are able to control the supply and demand which affects the cost of buying a bond. When supply is not as great, the cost of purchasing that debt increases.
The financial crisis of 2007-2008 was brought on by default of several Credit Default Swaps that were issued by the American Insurance Group. Investors bought CDS protection against the bonds of mortgage-backed securities which were acquired from this insurance company. When the housing market collapsed in 2006 and 2007, defaults on these types of mortgages increased dramatically. The investors who bought this insurance lost their money and this put AIG into bankruptcy due to having to make all of those payments out. It was a significant contributing factor to their demise because it exceeded $120 billion dollars in exposure for them. The U.S. government stepped in and bailed out AIG so they wouldn’t have to pay those high costs, but they still went bankrupt.
Credit default swaps are not only risky for the protection buyers who deal with these insurance contracts; they are also risky for protection sellers because most of these deals don’t require collateral or a margin in order to purchase them. If there is a company, like AIG, that sells too many CDS protection contracts without having enough money on hand, it will go bankrupt. This means that the investor who bought that default insurance from that company will lose money and so will the insurance company if it doesn’t have the capital on hand to pay those investors out instead of going into bankruptcy itself.
More than half of the world’s credit default swaps are sold in London and New York with almost $60 trillion in notional value outstanding according to the Bank for International Settlements. It is one of the most heavily traded instruments for derivatives. The insurance industry is still responsible for the majority of credit default swap activity, but hedge funds and other entities like investment banks have been increasing their participation in this market. There are also a number of non-traditional institutions that have become active players as well. These types of players, in addition to the traditional players, may also serve as counterparties for credit default swap trades. These non-traditional market participants have become significant because they are offering a broader range of products, including credit derivative contracts referencing debt instruments from new sectors like consumer loans and commercial real estate.
The market for credit default swaps is still growing very rapidly in comparison to other derivatives markets. By the end of 2011, notional amounts outstanding reached $62 trillion which is almost four times what it was at the beginning of 2008. The number of protection buyers doubled between December 2007 and December 2011 which means that there are more companies taking out these types of insurance contracts and holding them as assets on their books. This is a sign that this market has reached a level of maturity. The market is on the verge of saturation and there are still new players entering the market to try and deal with this. There are also other types of derivatives contracts being created by other parties like insurance companies in order to hedge their own risks in the face of growing credit risk.
CDS trading occurs on both primary and secondary markets. The contracts traded on these markets come in different types each with a different set of criteria that the buyer or seller must meet in order to sell or buy these contracts. For example, CDSs can be sold without health care counter-party risk since they are based on credit ratings alone. These contracts are bought by generating margin for the protection buyer. The margin is a percentage of the notional amount of the contract and is used to cover any potential losses if there is a default on the underlying asset. It can also be used to cover a payment for the credit insurer if there is an insurance payment that needs to be made.
There are different types of CDS structures in existence including plain vanilla, or “look through,” swaptions, caps, floors, and extensions. These are all derivatives that have different risk characteristics except they all reference credit default swaps as the underlying instrument. Credit default swaps have been around since the 1980s and are based on the idea of insuring companies against bankruptcy. It is a product that is related to collateralized debt obligations which were products designed to allow more businesses to borrow money while taking on more risks.
The plain vanilla CDS is traded on exchanges such as the Chicago Mercantile Exchange or the New York Commodities Exchange. These are not regulated exchanges, but they do adhere to certain rules in order to make sure that the contracts are not manipulated by dealers and market makers. Derivatives like these can be used as a hedge against other derivatives contracts like options or futures contracts which reference the same underlying issuers, but not credit derivatives.
Swaptions have the risk of being used as a hedge against a corporate bond but are not considered to be CDSs. Swaptions are essentially a derivative that references the same underlying instrument used to reference other types of derivatives.
Caps, floors and extensions all have different features that make them different from one another. They all reference the same underlying contract and they are used as a protection or insurance product in order to protect an investor from default risk against an asset like equity, equities or interest rate contracts. This can be another way for investors or corporations trying to protect themselves from credit risk but it is not considered a CDS since it does not reference credit default swaps.
It is important to remember that all these different types of CDS contracts reference the same underlying instrument. When you look at the trade structure of these contracts, there are similarities across all the different types of CDSs. They are all based on insuring debt instruments and they are all traded on exchanges like the Chicago Mercantile Exchange or the New York Commodities Exchange. All of them are bought and sold in derivative form by using margin, which is set on a percentage basis and can be used to loan out money in order to buy the contract. These derivatives generally refer to certain debt instruments like bonds, convertible bonds, preferred stock, or subordinated debt with fixed interest rate obligations (fixed rate bonds).
The way that the CDS market works is that as time goes on, more of the insurance contracts have been created in response to new risks. What has also happened is that there have been different types of products designed to protect various financial assets from credit risk. These products are derivatives, but because they do not reference CDSs directly they are considered separately by industry experts and regulators. There are a number of different ways to calculate the performance of the CDS market, but one metric currently being used comes from Bank of America Merrill Lynch which estimates an annualized growth rate of 11% for all credit derivative contracts since 2008.
Credit default swaps can be used for hedging or speculation. They are used by investors in order to hedge their own risks or to bet against companies that are having trouble repaying their debts. Because these instruments have so many different types, they can be used by investors for a number of different purposes. All of these contracts reference the credit default swap market, but as trade instruments there are differences in what they represent and where they are used. Many financial institutions use CDSs as a way to hedge their own risk, but others use them like currency speculators who want to make money on rising and falling risk factors.
The credit default swap market is currently worth over $25 trillion in size according to Bank of America Merrill Lynch. That is about 20% of the total capitalization of the global government bond market. In 2010, that figure was $22 trillion and since 2008 that number has increased by 11%.
The biggest players in CDSs are the dealers, who are banks and other financial institutions. When CDSs were first traded, they were exchanged through electronic platforms where participants would enter into a deal with another individual or institution using a computer terminal. This was known as an “open outcry” exchange where trading was done verbally on an exchange floor and deals were done right then and there without any type of paper documentation or confirmation. Today, many of the larger banks have their own internal CDS trading platforms and they are also traded on exchanges. The CDSs are generally bought and sold five days after they are issued, which is seven to ten days from the time that a new contract is created.
CDS contracts can be used for hedging or speculation purposes, but because of the relatively short life span of CDSs it does not make sense to hold them if you do not plan to keep them until maturity. The typical amount of time that a credit default swap will be held is one year which means that, according to Bank of America Merrill Lynch, approximately half of the current market value will have expired before it ever needs to be paid off.
