New on FinoLib · Volume II: Capital Markets
New on FinoLib, my finance education website: I have published an article called Credit Default Swaps (CDS) Explained: Hedging vs Speculation, from Volume II: Capital Markets. Here is what the article explains, written as a short expert briefing; the full piece, with every worked example, is one click away.
4.7 Credit Default Swaps (CDS)
The idea in plain words
A credit default swap is insurance on a loan. The protection buyer pays a yearly fee, called the spread, and if the borrower defaults, the seller pays the loss. The spread roughly equals the chance of default times how much is lost when it happens. Headline sizes can mislead: Lehman Brothers had $72 billion of these contracts registered, but after offsetting them against each other only about $5.2 billion actually had to change hands.
Key points
■Credit triangle: 2% default probability × 60% loss = 120 basis points; 300 basis points at 40% recovery implies 5% a year.
■Lehman’s October 10, 2008, auction set recovery at 8.625%; netting, not recovery, shrank the payments.
■Standard contracts since April 8, 2009, pay a fixed 100 or 500 basis point coupon plus an upfront amount.
A closer look
A credit default swap functions like insurance against a bond issuer defaulting. The “protection buyer” pays a regular premium (the CDS spread, quoted in basis points per year) to the “protection seller.” If the reference entity (the bond issuer) experiences a defined credit event — bankruptcy, missed payment, or a forced debt restructuring — the protection seller compensates the buyer for the loss, typically the difference between the bond’s face value and its post-default market value.
Decision rule
Convert every spread into an implied default probability, spread ÷ (1 − R), and compare it with your credit view or the rating’s historical default rate; if the market implies far more, find out what it knows before selling protection. Buy protection to hedge a loan only on matching maturity and seniority, and only from a cleared or fully collateralized counterparty: protection from a seller that cannot pay in a crisis is worthless.
The costliest mistake
Selling protection as if the premium were safe income. Writing $100 million of protection at 120 basis points earns $1.2 million a year. If the name defaults with Lehman’s 8.625% recovery, the seller pays $100,000,000 × 0.91375 = $91.4 million, the premium of 91.4 ÷ 1.2 ≈ 76 years, in one settlement. Sellers who wrote such protection across many correlated names, without the liquidity to meet collateral calls as spreads widened, are the ones crises break. Size protection sold by the payout at a realistic recovery, never by the spread income.
Recap
A CDS spread approximates default probability times loss given default, so spreads convert into market-implied default rates. Netting reduced the $72 billion of Lehman CDS registered with DTCC to about $5.2 billion of net payments after the October 2008 auction set recovery at 8.625%; the real danger lay with one-way sellers such as AIG.
4.8 Hedging vs Speculation — Using Derivatives in Practice
The idea in plain words
Hedging and speculating use the same tools. What separates them is whether the position offsets a risk you already have. If your company will receive foreign currency, selling that currency forward is a hedge; the same trade with no underlying exposure is a bet. Size a hedge to the exposure using a hedge ratio. Forwards give certainty, while options work like insurance: you pay a premium to keep the upside. Always judge the hedge together with the exposure, never alone.
Key points
■Minimum-variance hedge ratio h* = ρ × σS ÷ σF, 0.96 in the airline example.
■For a €10 million payable, the forward costs $11,529,841 in every scenario; a 1.1530 call caps the cost at $11,874,823.
■The call beats the forward below 1.1185 and beats staying unhedged above 1.1875.
Decision rule
Call a position a hedge only if it offsets an exposure you carry or are committed to, its notional is at most 100% of that exposure (lower, say 50% to 80%, for forecast flows), its size follows the hedge ratio, and you can fund its margin under stress. Otherwise treat the excess as a trading position with its own limits. Use a forward for certainty, an option when the exposure is uncertain (a bid you may not win).
The costliest mistake
Over-hedging and booking the excess as risk management. An airline that will burn 10 million gallons buys futures on 15 million because “prices can only go up.” If fuel falls $0.80 a gallon, futures on the 10 million lose what the airline saves at the pump, but the extra 5 million lose 5,000,000 × $0.80 = $4.0 million with no offset: a speculative loss under a hedging label. Cap notional at forecast exposure and have someone outside the desk check it monthly.
What the full article covers
In the full article I take you through these sections:
■4.7 Credit Default Swaps (CDS)
■4.8 Hedging vs Speculation — Using Derivatives in Practice
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Credit Default Swaps (CDS) Explained: Hedging vs Speculation, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance