Credit Derivatives and CDS

Credit derivatives are instruments that allow the transfer of credit risk from one participant to another without the physical transfer of the underlying asset. The largest segment is Credit Default Swaps (CDS). The credit derivatives market peaked at over $60 trillion in 2007; after the crisis it contracted, but remains significant (about $9–10 trillion notional).

CDS: Structure and Mechanics. The protection buyer pays a periodic spread (CDS spread in basis points × notional) to the protection seller. In the event of a credit event, the seller compensates the buyer for the loss. Credit events: Bankruptcy, Failure to Pay, Restructuring (modifications vary). Physical settlement: the protection buyer delivers defaulted bonds and receives the notional amount. Cash settlement: the difference between the notional and market price is compensated (determined at an ISDA auction).

CDS spread as an indicator of credit risk. The 5-year CDS spread is the most traded. The CDS spread reflects the market's assessment of PD × LGD. Approximately: CDS spread ≈ PD × (1 − Recovery Rate). With a spread of 100 bps and a recovery rate of 40%, the implied PD will be about 1.67% per year. CDS spreads reflect changes in credit quality more promptly than bond spreads. CDS are used as indicators of sovereign risk — Greek CDS in 2010–2012, Russian CDS in 2022.

Index CDS. CDX (USA): a family of CDS indices from IHS Markit — CDX.NA.IG (125 Investment Grade issuers) and CDX.NA.HY (100 High Yield issuers). iTraxx (Europe): analogous indices. They are liquid and traded in larger volumes than single-name CDS. Used for tactical hedging and expressing macro views.

Regulation and Systemic Risk. The 2008 crisis exposed the systemic risk of CDS: AIG accumulated $440 billion in CDS protection without sufficient collateral — the government was forced to bail out the company. Reform: Dodd–Frank and EMIR laws required standardized CDS to be cleared through central counterparties. ICE Clear Credit is the largest CCP for CDS. ISDA standardizes documentation (ISDA Master Agreement) and manages Credit Event auctions.