Introduction to Credit Derivatives and Credit Default Swaps

By Janet Tavakoli

Credit derivatives grew from an estimated $3 trillion notional* amount with a gross market value of $89 billion in the first quarter of 2003 to an estimated $24.3 trillion notional* amount with a gross market value of $725 billion in June 2013.

*notional--existing as an idea rather than as something real

The most common type of credit derivative is the credit default swap.

A credit default swap or option is simply an exchange of a fee in exchange for a payment if a credit default event occurs.

Credit default swaps differ from total return swaps in that the investor does not take price risk of the reference asset, only the risk of default.

The investor receives a fee from the seller of the default risk.

The investor makes no payment unless a credit default event occurs.

Plain Vanilla Credit Default Swap

The traditional or “plain vanilla” credit default swap is a payment by one party in exchange for a credit default protection payment if a credit default event on a reference asset occurs.

The amount of the payment is the difference between the original price of the reference asset and the recovery value of the reference asset.

The following schematic shows how the cash flow of this credit derivative transaction work:

If the fee is paid upfront, which may be the case for very short dated structures, the agreement is likely to be called a credit default option.

If the fee is paid over time, the agreement is more likely to be called a swap.

Unless two counterparties are actually swapping and exchanging the credit default risk of two different credits, I prefer to call the former structure a credit default option.

Cash flows paid over time are nothing more than an amortization of an option premium.

Because the documentation references ISDA master agreements, however, swap terminology has crept into the market.

Since the credit derivatives business at many commercial and investment banks is often run by former interest rate swap staff, the tendency to use swap terminology persists.

Therefore, I will most often refer to these transactions as credit default “swaps.”

The credit default premium is usually paid over time.

For some very short dated structures, the credit default premium may be paid upfront.

 Professionals new to this market often ask if the premium should be paid upfront, instead of over time.

After all, if the credit defaults, the default protection seller will get no additional premiums.

Credit Default Option Is Contingent

The credit default option or swap is a contingent option, and not to be confused with an American option.

A termination payment is only made if a credit event occurs.

If the credit event does not occur, the default protection seller has no obligation.

The premium can be thought of as the credit spread an investor demands to take the default risk of a given reference asset.

If the investor bought an asset swap, the investor would earn a spread to his funding cost representing the compensation, the premium, the investor would need to take the credit default risk of the reference asset in the asset swap.

For an American option, the premium is paid upfront (or over time, but with the proviso that the total premium is owed, even if exercise occurs before the expiration date).

The American option can be exercised any time that it is in the money.

The holder of the option does not have to exercise, however, and can wait and hope the option will go further in the money.

If the market reverses direction, the American option can again become out-of-the money, and the holder who failed to exercise the option when it was in the money cannot exercise.

With a credit default option, once the trigger event has occurred, the holder must exercise and the option stays exercisable.

Default protection can be purchased on a loan, a bond, an index of reference obligations, sovereign risk due to cross border commercial transactions, or even on credit exposure due to a derivative contract such as counterparty credit exposure in a cross currency swap transaction.

Credit protection can be linked to an individual credit or to a basket of credits.

At first glance, a credit default swap or option looks structurally simpler than a total return swap.

 A total return swap is a form of financing, and the total return receiver has both market risk and default risk; a credit default swap is embedded in the structure.

The first key difference is that although the price or premium of a credit default swap or option may increase, it is never actually in-the-money until a credit default event, as defined by the confirm language, has occurred.

That seems like a knock-in option or a knock-in swap, which is a type of barrier option.

Knock-in options have been around since the 1960’s.

When a market price reaches a predetermined strike price, the barrier, the knock-in option comes into existence.

But this “knock-in” is not linked to traditional market factors, but rather to either credit default or a credit “event.”

If the option “knocks in” then, and only then, is the option in the money.

The termination payment is usually not binary or predefined, although it can be if both parties agree.

The termination payment is linked to a recovery value or recovery rate for the reference credit or reference credits involved.