Investments, tenth edition

  Credit Default Swaps 

 A    

 

credit default swap (CDS) 

   

is in effect an insurance policy 

on the default risk of a bond or 

loan. To illustrate, the annual pre-

mium in July 2012 on a 5-year 

German government CDS was 

about 0.75%, meaning that the 

CDS buyer would pay the seller 

an annual premium of $.75 for 

each $100 of bond principal. The 

seller collects these annual pay-

ments for the term of the contract 

but must compensate the buyer for 

loss of bond value in the event of a 

default.  

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–4

0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

4

8

12

16

20

Yield Spread (%)

High Yield

Baa-Rated

Aaa-Rated

 Figure 14.11 

Yield spreads between corporate and 10-year Treasury 

bonds 

   Source:  Federal Reserve Bank of St. Louis. 

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 Actually, credit default swaps may pay off even short of an actual default. The contract specifies the particular 

“credit events” that will trigger a payment. For example, restructuring (rewriting the terms of a firm’s outstanding 

debt as an alternative to formal bankruptcy proceedings) may be defined as a triggering credit event. 

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P A R T   I V

 Fixed-Income 

Securities

 As originally envisioned, credit default swaps were designed to allow lenders to buy pro-

tection against default risk. The natural buyers of CDSs would then be large  bondholders 

or banks that wished to enhance the creditworthiness of their outstanding loans. Even if the 

borrower had a shaky credit standing, the “insured” debt would be as safe as the issuer of the 

CDS. An investor holding a bond with a BB rating could, in principle, raise the effective 

quality of the debt to AAA by buying a CDS on the issuer. 

 This insight suggests how CDS contracts should be priced. If a BB-rated corporate 

bond bundled with insurance via a CDS is effectively equivalent to a AAA-rated bond, 

then the premium on the swap ought to approximate the yield spread between AAA-rated 

and BB-rated bonds.  

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   The risk structure of interest rates and CDS prices ought to be 

tightly aligned.

 

  Figure 14.12 , panel A, shows the premiums on 5-year CDSs on German government 

debt between 2008 and 2012. Even as the strongest economy in the eurozone, German 

CDS prices nevertheless reflect financial strain, first in the deep recession of 2009 and 

then again in 2011 as the prospects of defaults (and German-led bailouts) of Greece and