“A credit default swap (CDS) is a bilateral agreement designed explicitly to shift credit risk between two parties. In a CDS, one party (protection buyer) pays a periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity”.
Credit Default Swaps (CDS) are by far the most popular credit derivatives and have proven to be the most successful financial innovation. The structure of CDS is somewhat similar to the insurance policy. The market of CDS has heavily expanded and is traded in Over-The-Counter (OTC) market.
This essay will briefly address the structure and the market of CDS, outlining its common products usage by some large institutions. Following the review of financial structure and pricing of CDS. And finally, this essay will also evaluate the risk management and investment applications of such products.
Table of Contents
1. Introduction
2. Literature Review
3. Application
3.1 Development of the CDS Market
3.2 Pricing and Valuation of CDS
3.3 Risk Management and Investment Applications
4. Conclusion
Objectives and Topics
This paper provides a comprehensive overview of Credit Default Swaps (CDS), examining their structure, market evolution, and role in the global financial system, while evaluating their utility in risk management and investment applications through both qualitative analysis and mathematical pricing models.
- Fundamental structure and bilateral nature of CDS contracts.
- Historical market growth and the impact of the global financial crisis.
- Theoretical foundations for CDS pricing, including no-arbitrage and probability models.
- Practical application of valuation tools and risk management strategies.
- Analysis of systemic risks and counterparty concerns in the CDS market.
Excerpt from the Book
3.1 Development of the CDS Market
In 1998 and 1999, the International Swaps and Derivative Association (ISDA) originally created a standard contract credit default swap (CDS), to be traded in the OTC market. Since then, the growth of the CDS market has rapidly increased.
“According to Bank for International Settlements (BIS), in terms of gross market value, the CDS market value increased from USD 133 billion in Dec 2004 to USD 5.7 trillion in Dec 2008 and constitutes the second largest market value after the interest rate contacts”. (European Central Bank, 2009) Other sources say that the outstandings in the credit default market at year 2007 were USD 62.2 trillion, but this number declined to USD 38.6 trillion at December 2008 because of the financial crisis. The outstandings for 2009 are measured at USD 30.4 trillion. For the year 2010 a growth is expected again. (ISDA Market Survey, 2009)
The reason was mainly due to the re-pricing of the credit risk and the increase in the volatility in the market during this period. However, in contrast to figure 2, the second half of the year 2008, there was a significant drop in the CDS market size.
Summary of Chapters
1. Introduction: Introduces the Credit Default Swap as a bilateral agreement for shifting credit risk and outlines the scope of the essay regarding structure, pricing, and risk application.
2. Literature Review: Defines CDS as liquid, tradable instruments similar to insurance that allow parties to hedge against credit events and reference entity defaults.
3. Application: Examines the growth of the market, the technical methodologies for pricing (including the ISDA Standard Model), and the implications for risk management and systemic counterparty risk.
4. Conclusion: Summarizes the paper's findings, affirming the continued importance of CDS in financial markets despite past volatility and the necessity for effective regulatory oversight.
Keywords
Credit Default Swaps, CDS, Financial Derivatives, OTC Market, Risk Management, Default Probability, Pricing Models, No-arbitrage, Counterparty Risk, Systemic Risk, ISDA, Credit Event, Valuation, Financial Crisis, Hedging
Frequently Asked Questions
What is the core focus of this research paper?
This paper focuses on the nature, function, and valuation of Credit Default Swaps, providing a detailed overview of how these instruments operate within the Over-The-Counter market.
What are the primary thematic areas covered?
The central themes include the historical development of the CDS market, the mathematical approaches to pricing and valuation, and the role of CDS in managing corporate and banking credit risks.
What is the primary goal of this study?
The primary goal is to provide a holistic overview of CDS, covering everything from basic definitions and structural components to advanced valuation models and practical risk management applications.
Which scientific methods are employed?
The author uses a combination of literature review, descriptive analysis of market data, and quantitative examination of pricing models, specifically the no-arbitrage and probability-based approaches.
What topics are discussed in the main body of the work?
The main body covers market growth dynamics, detailed explanations of the ISDA Standard Model for pricing, the use of Excel-based models to demonstrate valuation, and an analysis of counterparty risk concerns.
Which keywords best describe this work?
Key terms include Credit Default Swaps, financial derivatives, risk management, default probability, and valuation models.
How is the "no-arbitrage" model applied in the text?
The text uses the no-arbitrage model to show how investors can replicate a credit risk exposure using a portfolio of risk-free assets and underlying bonds, thereby determining a unique, arbitrage-free premium payment.
How does the author characterize the "young" CDS market?
The author describes the market as having experienced rapid growth and impressive performance, though it faced significant challenges and scrutiny during the 2008 financial crisis, leading to calls for better transparency and regulation.
What role does the ISDA play in the context of this paper?
The ISDA is presented as the primary body for standardizing CDS contracts and providing the "ISDA CDS Standard Model," which serves as the benchmark for pricing and converting between spreads and upfront payments.
- Quote paper
- Panagiotis Papadopoulos (Author), 2010, Credit Default Swaps - Pricing, Valuation and Investment Applications, Munich, GRIN Verlag, https://www.grin.com/document/170187
