A Credit Default Swap (CDS) is a bilateral contract in which one party (the protection buyer) pays a periodic premium to another (the protection seller) in exchange for compensation if a reference entity defaults.
Mechanics
The buyer pays a fixed spread — say 80 basis points annually — on the notional amount. If the reference entity triggers a credit event, the seller pays par minus recovery value, or physical delivery of the defaulted obligation.
CDS contracts reference the ISDA Credit Definitions, which define qualifying credit events: bankruptcy, failure to pay, restructuring (with regional variants).
Uses
- Hedging: a bond holder buys CDS protection to offset credit exposure without selling the bond.
- Speculation: taking a view on credit quality without holding the underlying debt.
- Basis trading: exploiting the spread between CDS and the underlying bond.
Counterparty Risk in CDS
The instrument designed to transfer credit risk itself carries credit risk: if the protection seller defaults at the same time as the reference entity, the hedge fails precisely when needed most.
This wrong-way risk — where counterparty exposure and market value of the position are positively correlated with the counterparty's default probability — is one of the most dangerous risks in OTC derivatives.
Post-2008 regulation addressed this through central clearing (CCPs now clear most standardized CDS), mandatory Initial Margin and Variation Margin under EMIR/Dodd-Frank, and bilateral Credit Support Annexes (CSAs) for uncleared trades.
CVA: Pricing Counterparty Risk
Credit Valuation Adjustment (CVA) is the market value of counterparty credit risk — the cost of hedging expected exposure weighted by probability of default. Under Basel III, CVA capital charges incentivize moving trades onto cleared venues or hedging CVA explicitly.