Credit default swaps explained

How and why credit default swaps are used.

A credit default swap (“CDS”) is a derivative contract that is similar to an insurance policy where the buyer of the contract makes periodic payments to the seller, and in return receives a one off payment from the seller if there is a default on an underlying financial instrument.  Underlying financial instruments are typically bonds or loans.

As an example, an investor could purchase a five year CDS on a $10 million parcel of Telstra bonds from NAB at a price (or credit spread) of 0.80% per annum.  The investor will pay NAB $20,000 every three months ($80,000 per annum) for five years.  If Telstra defaults on the bonds during the five years, for example it fails to make an interest payment on time or goes into administration, NAB will make a $6 million compensation payment to the investor based on the assumed loss incurred on the particular Telstra bonds.  Most CDS assume a 40% recovery rate, that is they assume that if Telstra defaults on its bonds, investors won’t lose all their money, but will recover 40% of their investment.

In this example, if the investor wished to sell CDS,  in return for receiving the regular premium the investor would need to provide a margin deposit so that the buyer of the CDS could be confident of receiving the $6 million compensation payment if Telstra defaulted on its bonds.

CDS are traded over-the-counter and are used for a variety of purposes including hedging or reducing default risk, as well as speculating on changes in the price of credit for a particular entity.

The CDS market was first developed in 1997 by JPMorgan Chase to shift the risk of default on certain companies that it had lent to.  As at the end of 2017, the estimated notional value of outstanding CDS contracts is over US$9 trillion.

The iTraxx Australia Index measures the average cost of a five-year CDS on the 25 most-traded CDS in the Australian market.  Companies in the index include Woolworths, the big four banks, Rio Tinto and Amcor.  The current iTraxx Australia Index price is around 0.73% per annum but the index has traded in a range of as low as 0.24% in June 2007 before the financial crisis to a high of 4.41% in the March 2009 in the depths of the financial crisis and since then the index has tended to move inversely with equity markets - falling when equity markets rise and vice versa.

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