Financial Update (Second Quarter 2008)

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A Primer on Credit Default Swaps
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Severe credit crises in the 1980s prompted financial institutions to look for methods of mitigating and diversifying credit risk. One such instrument is a credit derivative, an over-the-counter financial contract that allows for the transfer of credit risk from one party to another.

The most widely traded type of credit derivative today is a credit default swap (CDS). Introduced in the mid-1990s, CDSs were not popular at first, but in recent years CDS trading has skyrocketed. The amount of CDSs totaled just under $1 trillion as of year-end 2001, according to the International Swaps and Derivatives Association, but increased to over $45 trillion through midyear 2007. (These amounts are notional—the face amounts used to calculate payments on the contracts.)

Podcast on credit derivatives
Q4 2007 Economic Review: A Special Focus on Credit Derivatives
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Initially, most CDSs were written on single entities such as large manufacturing firms or financial institutions, but since 2004 the major growth in the market has been CDSs on indexes.

How does a CDS work?
A CDS is a contract in which one party pays a fee to transfer the credit risk of an underlying third-party fixed-income claim such as a corporate bond to another party for a specified period of time. A CDS thus functions as an insurance policy in which the buyer receives credit protection and the seller guarantees the creditworthiness of the underlying claim.

For example, a pension plan owns a risky bond issued by Company A and is concerned about repayment. To protect itself from the risk of nonpayment by Company A, the pension plan can buy a CDS contract on Company A.

In a CDS, if a prespecified "credit event" occurs, such as bankruptcy, failure to pay, or restructuring (adverse to creditors), the seller pays compensation to the buyer. This compensation usually requires some physical delivery with a "cheapest-to-deliver" option. Cash settlement is also sometimes an option.

Most CDSs are in the $10 million–$20 million range with maturities between one and 10 years. The buyer of a CDS typically pays the seller a quarterly fixed premium—often called the spread—that is market-determined based on the term and notional amount of the contract. For example, say the five-year CDS spread for Company B is 160 basis points annually. An investor wishing to hedge $10 million in exposure to Company B for five years would pay 40 basis points, or $40,000, as a quarterly premium.

Who's in the CDS market?
The largest players in the CDS market are commercial banks, which are net buyers of this credit protection. CDSs allow banks to transfer risks without moving assets off their balance sheets. Banks also sometimes sell CDSs as a way to better achieve industry or geographic diversification of risk. Various types of insurance companies are also large net sellers of CDSs.

April 14, 2008