Concept of CDS – credit default swap
A CDS credit default swap can be defined as “a bilateral agreement with the function of explicitly exchanging credit risk between two parties”, according to the International Swaps and Derivatives Association (ISDA).
In the credit derivative segment, one of the most significant instruments, whose role was very important in the development of the subprime crisis in 2007 and 2008, and the subsequent sovereign debt crisis that began in 2009 were the Credit Default Swaps (CDS ). Since in practice insurance is transacted between two parties to exchange credit risk underlying the obligations of a third party (reference entity), the buyer ensures payment of compensation from the seller of the contract in the event of a credit event1 with the issuer of the underlying asset.
Speculative default risk swap
It is thus considered as a speculative swap of default risk, offering investors a guarantee against default, ie the risk of default is transferred to the swap seller. If a country cannot comply, the holder of a default risk swap will always receive its money, and the losses will be borne by the seller. Investors can purchase these swaps and hedge against losses from various financial institutions, including banks and investment funds. These are held by investors who do not hold the underlying obligations. Speculators can acquire CDS with non-compliance by governments: the greater the probability of default, the higher the CDS, which acts as a guarantee against non-compliance.
Regulation of CDS – credit default swap
Initially and for several years, the CDS market was not regulated, several measures were introduced to scrutinize transactions and use of this instrument by regulators in the financial system, due to events such as the imminent probability of bankruptcy of the insurer AIG, a of the entities that most acted in the market as a seller of CDS.
Following the collapse of Lehman Brothers in 2008, and the subsequent introduction of regulatory and standardization requirements in the CDS market, this instrument was transacted with standard coupon dates, an advance coupon (paid at the top), and the coupon amount also standardized. In the European Union, and more properly, sovereign CDS usually transact with 25 bp and 100 bp coupons. The initial payment of the coupon that is now required represents the difference between the quoted spread and the standardized coupon. If the former is higher, the protection seller receives the payment, otherwise, the protection buyer receives. This prepayment is especially important for CDS of entities at risk of default, which usually charges a very high spread.
Some characteristics
A CDS agreement is summarized as follows: the buyer of the agreement agrees to pay a premium periodically, while the seller of the agreement agrees that in the event of a credit event happening to a particular reference entity, compensation will be paid to the buyer of the contract.
As a term of comparison, we can use the case of “insurance on a particular car, except that in the case of CDS the contract would be made on a particular brand, so any accident with a car of that same brand would provide the payment of the defined compensation. More specifically, since the contract refers to the class of debt covered, such as all subordinated debt, in the case of the car, it would mean that only accidents in vehicles of a certain range of the said mark would be taken into account for the payment of compensation.
The premium that is paid by the buyer of the contract, also called the spread, is defined as a percentage of the notional value of the reference instrument, quoted in basis points, and its annual value is typically divided by payments quarterly, which theoretically and according to certain assumptions should correspond to the difference between the interest rate obtained with the underlying asset and the risk-free interest rate, ie the bond spread.
