Techniques used on the credit derivatives market: credit default swaps

As a response to the need for credit risk protection, the credit derivatives market has seen substantial growth over the past few years. While the deteriorating credit status of a large number of issuers in 2002 contributed to the expansion of this market, this growth can also be ascribed to the broadening of the uses to which these credit derivatives are put, above and beyond their original function of providing protection. This article describes how credit default swaps (CDSs) work and how they are used, CDSs accounting for the lion’s share of the credit derivatives market. One characteristic feature of CDSs is their premium, which is expressed in basis points and constitutes the periodic cost of purchasing protection. As an initial approximation, this premium may be regarded as being equivalent to the spread between the bonds issued by reference entities (the risk on which the derivatives are used to hedge) and the level of the swap curve; however, for technical reasons this is not in fact the case. This differential between the CDS premium and the bond yield spread – commonly known as the basis – encourages the use of CDSs as a new instrument for arbitrage, investment and position-taking on the credit market. In addition to credit risk hedging, arbitrage strategies are put in place to take advantage of the fluctuations in the basis and thus obtain maximum benefit from the now recognised blurring of boundaries between the bond and credit derivatives markets. An illustration is given of their use in the context of sovereign risk. As one of the original sources of demand for protection, the sovereign CDS market constitutes an ideal testing ground for strategies regarding credit derivatives instruments.