Credit Default Swap as an Instrument for Arbitrage and Hedging

A credit default swap is a type of agreement which serves as a guarantee that the buyer will be compensated in case of default or another event. Examples of events include restructuring, failure to pay, and bankruptcy. Compensation is usually offered as the face value of the loan. This arrangement is risky for both parties. Also known as credit derivative contract, this instrument is also used for speculative purposes.

Types of Derivatives

The most commonly used derivatives include:

  • CDS
  • Credit default index swaps
  • Spread options and forwards
  • Asset swaps
  • Collateralized debt obligations
  • CDS on baskets of entities

    • Other examples include tranche-loss and first-loss CDS. They have common features with other instruments such as the nth-to-default and first-to-default CDS. In the case of nth-to-default credit default swaps, buyers are compensated for losses from the nth default. Some instruments are designed as portfolios of CDSs. There are notes with a variable or fixed interest rate whereby the coupon and principal payments are linked to a basket of credits. Some entities also invest in forwards and options, and the returns vary depending on changes in spreads. Options come in different varieties, including lookback, Asian, American, European, exotic, and others. Synthetic collateralized debt obligations and asset swaps are two other options for investors and examples of derivatives.

    Some instruments are fairly easy to understand while others are more complex. ABC SDCs, for example, are more complex while corporate solutions are relatively simple. The latter have common features with put options. Basically, buyers are protected against loss in case the value of a debt security declines due to a credit event. Physical settlement is another option. The buyer can choose from different obligations based on cost and other factors. There are three types to choose from, obligations of third parties, obligations of subsidiaries, as well as direct obligations. Floating amount events are another example that involves implied write-downs. An implied write-down involves two tranches – subordinate and senior as well as collateral. The asset used as collateral is overvalued. The problem with write-downs is that they reduce the net income. On the positive side, this is also a way to reduce the company’s tax burden.

    There are three ways to determine the payment amount – no, variable, and fixed cap. Buyers take different factors into account, including the state of the market, regulations, liquidity, the recovery rate, risk of default, and others.

    Models

    The no-arbitrage and probability models are used to determine pricing. The latter takes several factors into account, including the LIBOR and credit curve, the recovery rate, and the premium. The no-arbitrage model is based on the assumption that arbitrage involves a degree of risk.

    Arbitrage and Hedging

    Credit default swaps are used to hedge the risk associated with holding debt. Financial institutions often enter into formal contracts that protect them against loss in case of default. Another option is to sell the loan to a third party. The problem with this arrangement is that the consent of the borrower is required. In addition, a credit default swap can be used to hedge against concentration risk. This is the case when a bank maintains relationships with businesses that operate in certain sectors or industries. Swaps are used to hedge risk and diversify loan portfolios. Other market participants also use CDSs, including insurance companies, pension funds, and entities that invest in corporate bonds. The CDS can be used for capital structure arbitrage in case that stock values drop considerably. One problem is that misalignments occur due to various reasons, including market participants who are unwilling to invest in exotic instruments, as well as settlement differences.

    Other Types

    There are other types of instruments such as contingent, replacement, catastrophe, and non-deliverable swaps. The contingent CDS is a variation that is characterized by features such as fallback settlement mechanisms, physical reference derivative transactions, upfront premiums, and others. The loan CDS is yet another variety whereby the underlying instrument is a secured loan and not unsecured debt, bond, or another type of debt security. The spread is tighter in this case.

    Related Articles

    Types of Derivatives to Include in Your Investment Portfolio
    Derivatives come in many varieties, and their value is derived from an underlying asset such as an interest rate, index, or asset. Examples of underlying assets include market indexes, currencies, commodities, bonds, and stocks. Types of Contracts There are different financial instruments such as:...

    Hedge Funds Focus on High Returns and Aggressive Growth
    A hedge fund is a pool of investments that are part of an aggressively managed portfolio. In general, hedging refers to strategies that are designed to leverage risk. What Funds DoThey trade undervalued bonds, trade options, and stocks, use arbitrage, take short and long positions, and invest in...

    Yield on Debt Securities and Other Investment Instruments
    Yield refers to the amount of money that owners receive in exchange for investing in some security. It is a set rate of return on insurance policies, fixed income securities, and stocks and bonds. Investment Products that Offer ReturnIndividuals and companies invest in different products, including...

    Follow Tessa on