Credit Default Swap as an Instrument for Arbitrage and Hedging
A credit default swap is a type of agreement which serves as a guarantee that the buyer will be compensated in case of default or another event. Examples of events include restructuring, failure to pay, and bankruptcy. Compensation is usually offered as the face value of the loan. This arrangement is risky for both parties. Also known as credit derivative contract, this instrument is also used for speculative purposes.
Types of Derivatives
The most commonly used derivatives include:
Other examples include tranche-loss and first-loss CDS. They have common features with other instruments such as the nth-to-default and first-to-default CDS. In the case of nth-to-default credit default swaps, buyers are compensated for losses from the nth default. Some instruments are designed as portfolios of CDSs. There are notes with a variable or fixed interest rate whereby the coupon and principal payments are linked to a basket of credits. Some entities also invest in forwards and options, and the returns vary depending on changes in spreads. Options come in different varieties, including lookback, Asian, American, European, exotic, and others. Synthetic collateralized debt obligations and asset swaps are two other options for investors and examples of derivatives.
There are three ways to determine the payment amount – no, variable, and fixed cap. Buyers take different factors into account, including the state of the market, regulations, liquidity, the recovery rate, risk of default, and others.
The no-arbitrage and probability models are used to determine pricing. The latter takes several factors into account, including the LIBOR and credit curve, the recovery rate, and the premium. The no-arbitrage model is based on the assumption that arbitrage involves a degree of risk.
Arbitrage and Hedging
Credit default swaps are used to hedge the risk associated with holding debt. Financial institutions often enter into formal contracts that protect them against loss in case of default. Another option is to sell the loan to a third party. The problem with this arrangement is that the consent of the borrower is required. In addition, a credit default swap can be used to hedge against concentration risk. This is the case when a bank maintains relationships with businesses that operate in certain sectors or industries. Swaps are used to hedge risk and diversify loan portfolios. Other market participants also use CDSs, including insurance companies, pension funds, and entities that invest in corporate bonds. The CDS can be used for capital structure arbitrage in case that stock values drop considerably. One problem is that misalignments occur due to various reasons, including market participants who are unwilling to invest in exotic instruments, as well as settlement differences.
There are other types of instruments such as contingent, replacement, catastrophe, and non-deliverable swaps. The contingent CDS is a variation that is characterized by features such as fallback settlement mechanisms, physical reference derivative transactions, upfront premiums, and others. The loan CDS is yet another variety whereby the underlying instrument is a secured loan and not unsecured debt, bond, or another type of debt security. The spread is tighter in this case.
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