The definition of CDS
A CDS is known in the financial world as a credit default swap. Because it has a simple structure and flexible conditions, banks and investors use it in order to hedge their exposure to credit risk. It can be considered as a sort of insurance for a credit default or some specified events mentioned in the contract. The buyer of the protection pays a premium to the seller, and this premium is called the CDS spread. The premium is quoted in basis points per year of the contract’s notional amount and the payment is made quarterly (a basis point is 0.01 percentage point). If the events mentioned in the contract happen then the seller of the insurance will cover the losses of the buyer.
If a CDS has a spread of 976 basis points for a five-year Dubai debt it means that default protection for a notional amount of $1 million costs $97,600 per year (or $24,400 per quarter).
Because of their simple structure and flexibly, CDS contracts can be considered as an efficient financial instrument. The flexibility mainly refers to the fact that the contract can be adapted to the client’s needs for protection. The underlying asset can be any obligation with a certain cash-flow or a portfolio of such obligations, as for example: loans or bonds issued by corporations, financial institution or governments (also known as sovereign debt).
The main characteristics of a CDS contract are its legal structure, settlement, liquidity and valuation. As for the legal structure it’s very important to note the definition of a "credit event". Prior to 2002, a credit event was considered as:
- Obligation acceleration
- Obligation default
- Failure to pay
- Repudiation or moratorium
But soon after the Argentinean’s double attempt to restructure their national debt, restructuring was eliminated from the credit event definition.
As for the settlement, even thought it should be simple, in a multibillion OTC market it can encounter several problems. One of them is the lack of netting and margins in the OTC market, fact that can generate the build-up of high exposures. The ways in which the settlement can be made are: physical delivery of the reference security, physical delivery of equivalent asset or cash settlement.
Recent developments on the CDS market
The chart below illustrates the evolution of the total global financial market of CDS contracts. The data are semiannual and are extracted from the market survey effectuated in 2009 by the International Swaps and Derivatives Association (ISDA). This association also provides the standard type of contract. As we can notice, this market has had, in the recent years a high rate of growing and reached in the second semester of 2007 the record figure of more than $60 trillion.
It began developing in the early 1990’s and now it is a major part of the credit derivatives from the OTC market. In 2007, according to the BIS (Bank of International Settlement) Triennial Surveys 2007 the CDS market represented 88% of the credit derivatives traded on the OTC.
The CDS contracts for the emerging markets are more concentrated on sovereign entities whereas the global markets on corporate entities. The most liquid maturity is the one of five years but maturities up to 10 years exists.
The relationship between risks and CDS spreads
CDS spreads have a direct proportional relationship with the risk associated by the market/investors to the underlying assets. Markets react to unfavorable news by increasing the spreads and to favorable ones by decreasing the spreads. This does not mean, however, that the CDS market is able to anticipate future risks rightly.
We can illustrate this relationship between the spreads and the risk by taking the case of sovereign debts as representing the underlying securities of CDS. We will begin the exemplification with Dubai debt because their spreads were subject to high fluctuation recently and it has been highly volatile (that translates in risky in the finance world). Afterwards we will consider some weighted spreads and several European countries spreads, following their evolution from the beginning of the financial crises.
First, taking the example of Dubai sovereign debt, we have below a chart illustrating the spread for the CDS that covers against the risk of default on Dubai debt with the maturity of five-years. Dubai World is at the center of this debt, a conglomerate that from 1980’s has started a building boom, making Dubai a well-known city abroad
The period of time illustrated on the chart covers almost a year (from 4 september2008 until 26 November 2009). In this period we can notice that CDS spreads sky rocketed twice (October until February and 26 of November).
In the first two months of the year, doubts about the possibility of Dubai to pay the huge debts that were reaching maturity in February began increasing. This reflected in the increase of its CDS spreads treaded on the OTC market which reached the amazing value of 976 basis points in February. Soon came the news that Dubai will issue $20 billion dollars in treasury bonds, in order to gather the necessary resources to pay their debt and to continue with their development program. On the 23 February the central bank of United Arab Emirates (U.A.E.) decided to finance Dubai, by subscribing to a $10 billion debt (Dubai issued bonds).That day the investors reacted to the signal send by the central bank on the market and the spreads dropped 178 basis points.
After months of lower credit risk, on the 25 of November the city state representatives of Dubai announced debt-payments delays and asked for a moratorium of 6 months on their debts. As we can see from the chart, the spread increased again up to 541 basis points on 26 of November. From the chart above we can this draw the conclusion that a relationship exists between risk and spreads: spreads reflect the risk appreciated by market particpants.
But opinions over the capacity of CDS spreads to reflect and anticipate, at any time, the risk of the market can diverge significantly. Lord Turner, the president of the Financial Services Authority (FSA) of Great Britain sustains that CDS spreads and market prices failed to predict the risk accumulated in the financial system prior to September 2008. He outlines the idea that even if the spreads failed, the market commentators are still making the same mistakes now, by taking the spreads as a good measure of risks going forward.
He sustained in his speech held at the British Embassy in Paris on the 30 November 2090 that “…CDS spreads and equity prices for major banks provided us with no forewarning of the crisis: indeed, those who used CDS spreads to infer from the wisdom of markets the level and appropriate price of risk, would have concluded from these figures that the financial system had reached a point of historically low risk in spring 2007, the point we now recognize as that of maximum unrevealed fragility .The idea that market prices are always in some efficient market sense ‘correct’ should have died and been buried in this crisis. “
The graph below illustrates the opinion of Lord Turner. We notice that taking in consideration a larger period of time (from 2002 until 2008) we will have a more global vision of the evolution of market prices. CDS spreads are declining and share prices are increasing; these are all signs of a low risk market, but as the following events showed, that was not the case.
From the next chart we can observe that also the sovereign spreads for the countries included in the G10 failed indeed in measuring the risk before Lehman Brothers demanded bankruptcy protection. Only after 15 September, CDS spreads sky rocketed.
In the BIS 79th Annual report, five stages of the financial crises were identified. As we can see from the chart, bank CDS spreads (illustrated in green) increased slowly from the beginning of the crisis (Summer 2007). But they peaked only after the Lehman Brothers news, when a global loss of confidence hit the market (stage 3 on the chart). CDS market participants where, in a way, not extremely affected immediately after the Lehman Brothers failure. This was due to the fact that on the eve of the bankruptcy, a special session of clearing was performed on Sunday, the 14 September and AIG the national insurer that detained a large package of CDS contract, received government aid.
As we can notice from the behavior and evolution of different types of CDS spreads, they do a good job in measuring the risk perceived by investors about the underlying assets. The risk premium, however, is not necessarily a good predictor of the real risk. As financial theory teaches us, financial markets can be rational (they often are, although not always), but this does not mean that investors' expectations are necessarily exact. Recent developments on the CDS market have provided a perfect illustration of this.
- BIS 79th Annual Report, “The global financial crisis”,
- BIS Quarterly Review, December 2009
- BIS Papers No 44 “Financial globalization and emerging market capital flows”, December 2008
- Global Sovereign Credit Risk Report,3rd Quarter, 2009, CMA:
- Les Echos,2 Décembre, «Lord Turner : « La finance n’a pas retenu les leçons de la crise » »
- www .bloomberg.com