The Market Signs of Credit Default Swaps (CDS)

Credit Default Swap (CDS) is in effect an insurance policy on the default risk of a corporate bond or loan.

Credit default swaps were designed to allow lenders to buy protection against default risk. The natural buyers of CDSs would then be large bondholders or banks that wished to enhance the creditworthiness of their outstanding loans. Even if the borrowing firm had shaky credit standing, the “insured” debt would be as safe as the issuer of the CDS. An investor holding a bond with a BB rating could in principle raise the effective quality of the debt to AAA by buying a CDS on the issuer.

This insight suggests how CDS contracts should be priced. If a BB-rated bond bundled with insurance via a CDS is effectively equivalent to a AAA-rated bond, then the premium on the swap ought to approximate the yield spread between AAA-rated and BB-rated bonds. The risk structure of interest rates and CDS prices ought to be tightly aligned.

The picture shows the sharp run-up in the prices of 5 year CDSs on several financial firms in the months preceding the Lehman Brothers bankruptcy in September 2008. As perceived credit risk of these firms increased, so did the price of insuring their debt.

How to make money with CDS:

If an investor believes the firm’s credit prospects are poor in the near term and wishes to capitalize on this, the investor should buy a credit default swap.

When credit risk increases, credit default swaps increase in value because the protection they provides is more valuable. Credit default swaps do not provide protection against interest rates risk however.