Credit Default Swap: Synthetic CDO, Interest, & CDO-Index


What is a credit default swap?

A Credit Default Swap (CDS) is a financial contract through which the buyer of the contract makes a number of periodic payments to the seller and in return receives one protection in the form of a payment if the underlying so called the reference entity undergoes a credit event during term of the contract.

The contract can thus be compared with an insurance where the buyer insures against e.g. a bank to which it has lent money, ie. bought bonds or other promissory notes in, goes bankrupt. Maturity of The contracts are usually between 1 and 10 years. Most common are the 5-year contracts.

What is a synthetic CDO?

A synthetic collateral (CDO) is a multi-layered derivative product designed primarily for credit risk transfer purposes. It enables a diversified group of investors to gain exposure to a pool of debt instruments in order to make a profit.

Derivatives mean that they derive from reference / underlying assets, and in this case they are various debt instruments.

In a synthetic CDO transaction, the reference assets are not transferred to the investors.

This means that they take all the risks associated with the product without owning the underlying assets.

Who uses CDS contracts and why?

The largest issuers of CDS contracts are commercial banks. A vital part of banks’ operations involves credit risk as a result of their lending operations.

CDS trading offers a flexible tool for managing this risk exposure.

You can simply reduce and diversify their risk without removing assets from their balance sheet and without involving the borrowers.

If a bank instead chooses to change its risk exposure by restructuring outstanding loans, the borrower’s consent.

This is often a much more expensive and more complicated process.

CDS-INDEX

Until now, the discussion has been about individual CDS contracts which are linked to a specific reference entity, for example, a particular company.

In addition to these so-called “Single-name CDSs” there is also an index that consists of a basket of several different CDS contracts.

Usually, the division into a CDS index is based on that of the reference entity credit rating (eg investment grade or high yield) and geographical domicile.

Unlike individual CDS contracts, which are pure OTC instruments, trading in CDS indices is completely standardized, which usually leads to better liquidity and thus a more efficient and transparent trade.

It will be cheaper too banks and other financial institutions to “hedge” the risk in their bond portfolios.

Existence of CDS index enables smaller investors to, in a fairly simple way, speculate in credit risk at all. The risk is reduced due to diversification then the investor takes a broad view of some of the market’s total credit risk.

There are currently two main families of CDS indexes: CDX and iTraxx.

CDX provides indexes for companies in emerging countries and in North America while iTraxx is responsible for the rest of the world.

An example of a regular CDS index is iTraxx Main which follows CDS contracts from 125 European companies with the credit rating “Investment Grade ”.

TRADE WITH CDS CONTRACT

Trading in CDS contracts is usually carried out outside stock exchange or other regulated marketplace.

This type of trading goes by the name OTC trading (meaning over the counter) which means that the instrument is better suitable for institutional trade rather than private trade.

CDSs are usually traded regularly during its useful life and the value / price of the contract fluctuate over time based on the creditworthiness of the reference entity.

Read more about how pricing works below.

So, what is a swap?

A swap is a form of derivative instrument.

A swap is a financial instrument that usually involves an exchange of payment flows between two parties for an underlying nominal amount.

Swap is a financial instrument that involves an exchange of cash flows between two parties for an underlying nominal amount.

What is an interest rate swap?

An interest rate swap is an agreement to change interest flow for a certain period of time.

With an interest rate swap, two parties exchange a fixed term with each other without the companies’ balance sheets, underlying loans or investments being affected.

An interest rate swap can mean that a party with a loan with a variable interest rate wants to switch to a fixed interest rate to be sure of being able to pay even if the interest rate situation rises.

Swap agreement

If a person wants to enter into a swap agreement, he can turn to his bank and have the bank as a counterparty in a swap agreement.

When it comes to interest rate swaps, there is a standardized market to facilitate trading in these financial instruments.

Swap agreements can also be signed for amounts in foreign currency, a so-called currency swap.

Currency swap

Currency swaps can be useful when you have an outstanding currency forward that you will not be able to complete as planned, on the due date.

Then you can move the cash flows forward and avoid overdrawing the account.

A swap can also involve an exchange of an interest payment in foreign currency for an interest payment.

The word swap can also be used for certain values ​​exchange agreements, e.g. an exchange of the value of shares for the value of a bond.

It is very reminiscent of a term.

Conclusion

Basically, CDO is a type of asset-backed collateral (ABS), which can be supported by a variety of debt instruments, such as different types of bonds, bank loans, home-secured securities and many more.

If the pool consists of bond-type instruments, the CDO is called a collateral bond (CBO).

The CDO is also designated as a security loan obligation (CLO) if the underlying pool consists of a bank loan.

A CDO derivative is sold to investors just like all other debt securities.

Still feeling unsure about the topic? (I am not gonna lie, I had a hard time understanding this topic aswell) Then check out this video I found on Youtube:

Sources

https://www.researchgate.net/profile/Moorad-Choudhry/publication/247908019_Revisiting_the_Credit_Default_Swap_Basis_Further_Analysis_of_the_Cash_and_Synthetic_Credit_Market_Differential/links/54ef350e0cf2495330e1bb8e/Revisiting-the-Credit-Default-Swap-Basis-Further-Analysis-of-the-Cash-and-Synthetic-Credit-Market-Differential.pdf

https://www.cambridge.org/core/journals/journal-of-financial-and-quantitative-analysis/article/abs/determinants-of-credit-default-swap-premia/C90E99F64F47A41170EACD7F7A4929EE

https://www.sciencedirect.com/science/article/abs/pii/S0378426604001098

https://www.sciencedirect.com/science/article/abs/pii/S0304405X11002327

https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.2005.00797.x

https://onlinelibrary.wiley.com/doi/abs/10.1002/fut.10112

https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1468-036X.2013.12023.x

https://jod.pm-research.com/content/10/3/40.short

https://link.springer.com/article/10.1007/s10693-006-7626-x

https://www.sciencedirect.com/science/article/abs/pii/S0378426607002877

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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