The Fundamentals of CDS

Adair Turner's reversal would be humorous if it were not that he is chairman of the FSA. Yesterday he was crowing with the best of them of the evils of naked CDS, and today he is quoted as having said "that these so-called naked swaps weren't the 'key driver' of the Greek debt crisis and it would be wrong to ban them".

Now either the media has to start quoting what people actually say, or have we entered the age of Newspeak where the news is always updated to suit the new requirements?

At least the reports on Merkel and Sarkozy repeat their inane comments of yesterday essentially suggesting a crackdown on derivatives trading to prevent a rerun of the Greek crisis. Wait a minute. Yesterday they were screaming about credit derivatives, and today it's just derivatives. Maybe they realised they were a bit to forward on their skis?

So, today I will start a brief course on CDS. To start at the beginning, everyone who has ever purchased a corporate bond has participated in a credit derivative. They have essentially sold a put to the issuer. (A put is an option which allows the holder to "put" the instrument to the seller.)

A corporate bond is made up of the risk free rate-a reflection of the underlying level of treasuries of the same maturity; and a yield premium to reflect the fact there exists a higher risk in the corporate credit. This yield premium is the credit spread that an investor demands/is paid to invest in a corporate bond.

So for example GMAC issued a 10 year corporate bond today. It had a coupon of 8% as compared to the equivalent UST 10 year which has a coupon of 3.625. This differential of 4.375% (or 437.5 basis points)is the credit spread. How did it come about?

Well when one buys a corporate bond the starting point is what would the equivalent UST yield. In this case it yields 3.625%. The additional yield achieved is the result of the investor "selling a put"-in this case on GMAC back to GMAC. GMAC "pays" the investor 4.375% for this put which in the event that GMAC were to default the investor is left with (relatively) worthless GMAC credit. Unfortunately for the investor their risk is not just the additional spread they received, but also the "risk free" 3.625% they would have received if they had just bought a UST is at risk because they didn't buy a UST, they bought GMAC!

I will discuss how this imbedded option in a corporate bond became the CDS market tomorrow.