The use of credit default swaps (CDS) has grown in use over the last 19 years and currently make up a large volume of trading activity in credit markets. The total amount of outstanding credit default swap contracts in the begining of 2012 were estimated at $25.5 Trillion compared to $20B in 1996. The market sprung up in the 90's in response to the need of banks and financial institutions to hedge the risk of corporate clients defaulting on their loans or bond obligations.

 

What are credit default Swaps

 

Credit default Swaps (CDS) are financial contracts that enable the transfer of credit risk between two parties. The contracts are like insurance contracts because they provide protection to the buyer against default or any negative credit event. The contracts are usually sold by banks and are purchased by investors to protect against failure on their investments. The protection seller of the contract assumes the credit risk that the buyer does not want to take on and in exchange receives periodic fee payments from the buyer for the protection the seller provides. The seller is obligated to pay the buyer the dollar amount on a reference obligor that the buyer bought the protection on, incase of a negative credit event. The reference obligor can be a corporation, government or any issuer in the debt markets. The protection buyer pays the seller a quarterly swap premium fee for the life of the swap, until maturity or when a credit event occurs.

 

What is considered a credit event:

 

A credit event is considered as any situation which can cause the credit quality of a reference entity to deteriorate in value, for example a bankruptcy, failure to pay, or Restructuring. If a reference obligor credit event occurs the protection seller makes a physical or cash settlement payment to the protection buyer, after which the CDS contract is terminated. The settlement that the protection buyer receives from the seller after a credit event will be the par value (face value) of the reference obligor, even if the current value of the obligor has declined due to the credit event.

 

Credit default swaps used to be traded primarily by banks, but that has changed over the years with other institutional investors like hedge funds, pension funds and other investment firms actively participating in the market. Hedge funds made up about 31% of the CDS market in 2008 compared to a 40% drop in the participation of banks in the market that same year, according to data from the British Bankers Association.

 

Uses of Credit default Swaps

 

CDS are used by banks and other institutional investors for the following reasons.

 

Banks: primarily for hedging, investment and regulatory purposes.

Hedge funds: for speculation, carry trades and hedging.

Pension & mutual funds: for investment, fees and collateral enhancements.

 

Credit default Swap Indexes

 

CDS indexes were created over the years to support the market as their volume and sophistication grew. The three common CDS indexes in the U.S are the

 

• High-grade corporate bonds index - CDX.IG

• High yield corporate bonds index - CDX.HY

• Loans Index - LCDX

 

Credit default swap contracts in Europe are traded on the iTraxx index.

 

Credit default swaps continue to play an active role in the credit markets and will continue to constitute a significant portion of trading activity in the credit markets due to their increased importance in the hedging and isolation of risk