Monday, February 14, 2011

Derivatives Overview Part 3 - Credit Default Swaps

Credit default swaps (CDS) represent approximately 8% of the over the counter (OTC) derivatives market and in 2008 had a notional value of $55 trillion USD.   During the 2008 Financial Crisis, naked CDS was discussed regularly and compared to taking out insurance on your neighbor's house.  You had no interest in the property other than seeing it destroyed.  Credit default swaps though play an important role in the financial community beyond pure speculation.

  • Hedge against default risk

  • Increase investment opportunities between counterparties

  • Speculative trade / investment

The following is an example of how a credit default swap is used as it relates to the prior transaction between GEICO and GM (Part 2 - Interest Rate Derivatives).

GEICO can only invest in companies whose credit rating is above investment grade.  GM though has a below investment grade credit rating.  Without a credit default swap this deal cannot get done.  The credit default swap allows a third party with the proper credit rating to complete the deal.

Transaction - JPM has the investment grade credit rating needed by GEICO
GEICO buys a CDS from JPM for 2% of the notional value ($100 million)

GM sells debt at 6%
 at below investment grade
(after the use of an
interest rate derivative)

GEICO pays 2% to JPM
converting GM debt
to investment grade

JPM "sells" their investment
grade credit rating to GEICO
by guaranteeing GM's debt
against a default

The Result

GM sells their debt at below investment grade to GEICO at 6%
JPM sells a CDS to GEICO for 2% of notional value
GEICO purchased GM debt at investment grade and pays JPM 2%


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