Cds Spread

Cds Spread
But Texas, North Carolina, and Florida will see heady growth in finance support roles like credit analyst and financial risk specialist.
As an early warning sign of default, credit default swaps have had mixed success, says Fitch Ratings.
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Given the lack of early warnings from markets and rating indicators three years ago that big banks were failing, it’s no surprise that finance departments have looked for new ways to gauge the credit quality and counterparty risk of their financial-services partners and customers. One of the crystal balls they now look to is spreads on credit default swaps (CDSs).
But how much can finance rely on the spreads of these credit derivatives to provide clues that a financial institution or large corporate customer is faltering? A new Fitch Ratings study provides some answers.
A contract used to insure the holder of a bond against default by the issuer, a CDS can act as an indicator of default risk. The spread of a CDS indicates the price investors have to pay to insure against the company’s default. If the spread on a Bank of America CDS is 80 basis points, then an investor pays $80,000 a year to buy protection on $10 million worth of the company’s debt. As default risk rises, so does the spread (cost) of the CDS.
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The Fitch study shows that CDS spreads were not a reliable predictor of “credit events” —which include defaults on financial instruments, bankruptcies, and debt restructurings — during the financial crisis. This was especially true when the credit event was more than a year away.

Fitch examined the CDS spread movements of 18 corporations, six financial institutions, and three monoline insurers, all of which “defaulted” in some way. Using a standard formula that translates spreads into the probability a company will default, Fitch found that “CDS spreads do not appear to provide a leading signal of default risk for financial institutions.”

Twelve months prior to the credit problems encountered by Fitch’s sample of six financial institutions (including Lehman Brothers Holdings and Anglo Irish), the average CDS spread of the six was 199 basis points. That translates into an average one-year probability of default of 3.3%. When the firms’ credit events were only six months away, the PD had inched up to only 8.3%, meaning fewer than two of the six were expected to default. The CDS spreads of monoline insurers were a little more on track, registering a 63.8% probability of default 12 months out.

Credit default swaps are imperfect barometers, the study indicates, and may not reflect an entity’s fundamental creditworthiness, especially during times of market distress. They can produce “false positives,” says Fitch. In other words, the spread of a CDS can overstate the probability of default by the reference entity (the one whose debt is being insured).

For example, as of December 2008, a group of 29 real estate investment trusts had an average peak CDS spread of 1,154 basis points, implying a default probability of 19.2%, says Fitch. The 18 defaulting companies in Fitch’s sample had a similar spread in the same period. Yet in the ensuing 12 months none of these REITs had a credit event, while the 18 other firms all defaulted, went bankrupt, or restructured their debt.

Since CDSs are financial instruments, their spreads can reflect market liquidity, counterparty risks, and technical factors, such as the high leverage inherent in swaps, say Fitch analysts. A CDS is different from a bond, explains Robert Grossman, chief credit officer of Fitch Ratings. “It reflects the risk of the reference entity, but part of the risk is [also] that the counterparty might not be around to honor the contract,” he says.

In addition, since there are low margin requirements for credit derivatives, a small change in the instrument’s price could produce a large loss, forcing a firm to wind down its position quickly. That could exacerbate price volatility. Says the Fitch report, “Many market participants have a total return orientation based on shorter-term changes in the mark-to-market value of CDS positions; thus spreads do not necessarily reflect a longer-term horizon of fundamental credit risk.”

Despite their flaws, though, the monitoring of CDS spreads can help CFOs and treasurers differentiate relative credit quality across a collection of entities, especially nonfinancial companies. When Fitch compared the average spreads on the 18 defaulting corporates in its sample with the average spreads on an index of 50 high-yield debt issuers over the same time period, it found that the spreads on the defaulting corporates progressively widened relative to the high-yield group, starting 18 months before their credit events.

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Last Update: 7 Sep 2022 17:45 GMT+0

(*) Implied probability of default, calculated on the hypothesis of a 40% recovery rate.

This website is for information purposes. The information contained herein does not constitute the provision of investment advice.

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Originally formed to provide banks with the means to transfer credit exposure, CDS has grown as an active portfolio management tool. The performance of CDS, like that of corporate bonds, is closely related to changes in credit spreads. This makes them an effective tool for hedging risk, and efficiently taking credit exposure.
A CDS is the most highly utilized type of credit derivative. In its most basic terms, a CDS is similar to an insurance contract, providing the buyer with protection against specific risks. Most often, investors buy credit default swaps for protection against a default, but these flexible instruments can be used in many ways to customize exposure to the credit market.
CDS contracts can mitigate risks in bond investing by transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of a default or other credit event, from one investor to another.
In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of credit risk – who also tends to own the underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, bankruptcies and credit rating downgrades. (For a more detailed list of CDS credit events see the Commonly Established CDS Credit Events table below).
The graphic below illustrates the credit default swap transaction between the risk “seller,” who is also the protection “buyer,” and the risk “buyer,” who is also the protection “seller.”
The credit default swap market is generally divided into three sectors:
Credit default swaps provide a measure of protection against previously agreed upon credit events. Below are the most common credit events that trigger a payment from the risk “buyer” to the risk “seller” in a CDS.
The settlement terms of a CDS are determined when the CDS contract is written. The most common type of CDS involves exchanging bonds for their par value, although the settlement can also be in the form of a cash payment equal to the difference between the bonds’ market value and par value.
The CDS market was originally formed to provide banks with the means to transfer credit exposure and free up regulatory capital. Today, CDS have become the engine that drives the credit derivatives market. The growth of the CDS market is due largely to CDS’ flexibility as an active portfolio management tool with the ability to customize exposure to corporate credit. Today the CDS market represents more than $10 trillion in gross notional exposure1.
In addition to hedging credit risk, the potential benefits of CDS include:
The performance of credit default swaps, like that of corporate bonds, is closely related to changes in credit spreads. This sensitivity makes them an effective tool for portfolio managers to hedge or gain exposure to credit. Credit default swaps also allow for arbitrage oppor
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