Credit
swaps play vital role too
Oliver
Chen and Duan Jin-Chuan
(c) 2008
Singapore Press Holdings Limited
THE financial crisis now
gripping the world began last year with an increase in the number of defaults
of sub-prime mortgages in the United
States. But in the most recent iteration of
the crisis, the focus has shifted to something called credit default swaps, or CDSs. They were one of the major causes for the
near-collapse of the insurance giant AIG.
CDSs have been described as unregulated
instruments, arcane and toxic. Yet, like many financial instruments that seem
exotic to the layman, they have their uses in the modern financial
architecture. Because they will continue to have an important role in finance, CDSs need to be better understood by the public.
Simply put, a CDS is an
insurance against the default of a bond. And like all insurance, there are two
parties: the insurance buyer and the insurance seller. CDSs
play a useful role in allowing investors to reduce the risks of the bonds they
hold.
To understand how CDSs work, think of car insurance. With car insurance, the
owner of a car makes regular payments to the insurer. In return, the insurer
agrees to pay for damages to the car if an accident occurs.
With a CDS, the insurance
buyer makes regular payments of a fixed size - the insurance premium - to the
insurer. In return, the insurer agrees to pay for 'damage' to the bond in the
event of default by the bond issuer. The bond issuer in a CDS contract is
called the 'reference entity'. Default is typically referred to as a 'credit
event', which is analogous to a car accident.
To understand how this
works, we need to have some understanding of how bonds function. Take, for
example, a 10-year bond, issued by a hypothetical Reliable
Corporation, with a face value of $100 bearing annual coupons - or
interest - of 10 per cent. The bondholder receives $10 annually for 10 years,
at the end of which the bond matures and Reliable pays back the face value to
the bondholder. But if Reliable defaults at some time before the 10 years are
up, coupon payments stop. Debt resolution may take months or even years to wrap
up, but the market will quickly price the bonds at a fraction of their face
value. This is known as the recovery rate.
Suppose that an insurance
buyer, Wong, and an insurer, Ali, enter into a five-year CDS contract using
Reliable as the reference entity. Suppose also that Wong pays Ali $2 every year
for every $100 face value of Reliable bonds that he holds. This is the
insurance premium and is called the CDS spread. The CDS spread is usually
expressed in terms of basis points, which are hundredths of a percent. In this
example, the spread is 200 basis points. In the event of Reliable defaulting,
Ali will pay Wong an amount equivalent to 100 per cent minus the recovery rate
of the bond.
Before we turn to the
recovery rate, we need to understand the economics of this CDS arrangement. If
Wong owns the Reliable bond, he can use the CDS to insure against any loss in
the event that Reliable defaults. During the period the CDS is in effect, Wong
ends up receiving 8 per cent interest instead of 10 per cent on the Reliable
bond. This is the net result from the bond's 10 per cent coupon minus the 200
basis points paid for insurance, or the CDS, to Ali. Though Wong gets less than
the full amount on the bond's coupon, his principal is protected, so long as
Ali is able to provide the insurance.
In the event of a default,
the damage could be settled in two ways: by physical delivery and by cash
settlement. In the case of the former, Wong simply transfers the impaired
Reliable bond to Ali in exchange for its full face value. In the case of cash
settlement, there is a well-established 'credit event auction' mechanism.
Take this example: On Sept
15, Lehman Brothers filed for bankruptcy
protection, a credit event. Subsequently, a credit event auction was held on
Oct 10 to settle the CDSs that referenced Lehman Brothers. That auction set a recovery rate of
8.625 per cent, meaning that holders of the relevant CDSs
could receive $91.375 from their insurer for every $100 face value protection
that they purchased. This is in essence the insurance payout. Accordingly,
someone who held $100 of Lehman bond and also the CDS would get $100 - $8.625
as the value of the defaulted bond plus $91.375 from the seller of the CDS for
the damage to the bond. By contrast, someone who held $100 of Lehman bond
without the CDS would get just $8.625 - the value of the defaulted bond.
What determines the CDS
spread? For car insurance, the better the safety record the driver has, the
smaller the insurance premium he would pay. For CDS, the less likely the
reference entity is to default, the smaller the premium.
However, the analogy
between car insurance and CDS can only goes so far. The biggest difference is
that you can buy insurance only for your own car. In the case of CDS, you can
buy insurance on bonds that you do not even own.
Let's return to Wong, who
buys insurance through a CDS. Let's say Wong does not own any Reliable bonds.
Thus, Wong is essentially betting that Reliable will default in the next five
years. He pays Ali $2 per $100 face value each year. If Reliable defaults with
a recovery rate of 40 per cent, Wong will get $60 from Ali. However, if
Reliable does not default, he gets nothing.
Regardless of whether Wong
owns the bonds or not, if Reliable defaults and Ali cannot pay $60 to Wong,
then Ali will need to declare bankruptcy. Selling insurance on Reliable has
significantly increased Ali's risk. This was the situation AIG found itself in when
a large number of reference entities it issued CDSs
on either went into default or became a high risk to default.
While CDSs,
as well as those involved with them, have been much maligned in the media, they
do perform a vital function in risk management and should be viewed as a
positive financial innovation. They should not be completely prohibited.
Instead, better internal oversight within firms that use CDSs,
as well as external oversight by regulators, will better serve the market.
Dr Chen is director of the
Master of Science in Financial Engineering programme
at the NUS Risk Management Institute (RMI). Dr Duan
is the Cycle & Carriage professor of finance and director of RMI. This is
the eleventh article in the ST-NUS
Business School
Series on the financial crisis.
While credit default swaps
have been much maligned in the media, they do perform a vital function in risk
management and should be viewed as a positive financial innovation.