Brief Introduction to Credit Default Swaps

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Brief Introduction toCredit Default Swaps
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Credit Default SwapsBig Picture

• Credit default swaps neutralize credit risk
• This gives asset managers the flexibility to
  hedge and optimize their risk profile

Asset Without Credit Risk
Risky Bond Asset
Credit Default Swap

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Credit Default SwapsExpected Cash Flows on Bond
These payments are subject to credit risk (the
danger that
the issuer may default)
Principal
Payments to Holder by Issuer
. . .
Coupon
Coupon
Coupon
Principal
Payments to Issuer by Holder
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Credit Default SwapsCash Flows on CDS
. . .
Premium
Premium
Premium
Payments from Holder to CDS Seller
No default occurs (high probability)
Notional (Principal)
Payments from CDS Seller to Holder
Default occurs (low probability)
. . .
Premium
Premium
Payments from Holder to CDS Seller
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Credit Default SwapsCash Flows on Bond CDS
No credit risk in these payments
Principal
Net payments to Holder by Issuer and CDS Selle
r
. . .
Coupon - CDS Premium
Coupon - CDS Premium
Coupon - CDS Premium
Principal
Payments to Issuer by Holder
There is counterparty risk, however (the risk th
at the
CDS Seller will default)
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Credit Default SwapsSome Dangers

• Pricing assumes a particular probability that
  default will occur
  
• If it is gauged too low, the CDS Seller may have
  losses
  
• Default probabilities across bonds interact and
  are correlated
  
• If this is misgauged, a CDS Seller with multiple
  exposures may have losses
  
• AIG, for example, had large unhedged CDS
  exposures across many bonds