Investments, tenth edition

 Example  23.7 

Credit Risk in Swaps 

  Credit Default Swaps 

 Despite the similarity in names, a    credit  default  swap,      or CDS, is not the same type of 

instrument as interest rate or currency swaps. As we saw in Chapter 14, payment on a CDS 

is tied to the financial status of one or more reference firms; the CDS therefore allows two 

counterparties to take positions on the credit risk of those firms. When a particular “credit 

event” is triggered, say, default on an outstanding bond or failure to pay interest, the seller 

of protection is expected to cover the loss in the market value of the bond. For example, 

the swap seller may be obligated to pay par value to take delivery of the defaulted bond (in 

which case the swap is said to entail physical settlement) or may instead pay the swap buyer 

the difference between the par value and market value of the bond (termed cash settlement). 

The swap purchaser pays a periodic fee to the seller for this protection against credit events. 

 Unlike interest rate swaps, credit default swaps do not entail periodic netting of one 

reference rate against another. They are in fact more like insurance policies written on par-

ticular credit events. Bondholders may buy these swaps to transfer their credit risk expo-

sure to the swap seller, effectively enhancing the credit quality of their portfolios. Unlike 

insurance policies, however, the swap holder need not hold the bonds underlying the CDS 

contract; therefore, credit default swaps can be used purely to speculate on changes in the 

credit standing of the reference firms.    

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P A R T   V I

  Options, Futures, and Other Derivatives

  

9

 Robert A. Jarrow and George S. Oldfield, “Forward Contracts and Futures Contracts,”  Journal of Financial 

Economics  9 (1981). 

 Commodity futures prices are governed by the same general considerations as stock futures. 

One difference, however, is that the cost of “carrying” commodities, especially those subject 

to spoilage, is greater than the cost of carrying financial assets. The underlying asset for 

some contracts, such as electricity futures, simply cannot be “carried” or held in portfolio. 

Finally, spot prices for some commodities demonstrate marked seasonal patterns that can 

affect futures pricing.