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Credit Default Swaps

Credit Default Swaps

Understanding Investing Swaps

Originally formed to provide with the means to transfer credit exposure, CDS has grown as an active portfolio management tool. The performance of CDS, like that of corporate bonds, is closely related to changes in credit spreads. This makes them an effective tool for hedging , and efficiently taking credit exposure.

WHAT IS A CREDIT DEFAULT ? A COMMON A CDS is the most highly utilized type of credit . In TRANSACTION its most basic terms, a CDS is similar to an insurance contract, providing the buyer with protection against specific . Most often, investors buy credit default swaps for protection against PROTECTION SELLER a default, but these flexible instruments can be used in many • Does not usually own underlying credit asset ways to customize exposure to the credit . • Selling credit protection CDS contracts can mitigate risks in investing by • credit exposure transferring a given risk from one party to another without transferring the underlying bond or other credit asset. Prior to credit default swaps, there was no vehicle to transfer the risk of Credit default a default or other credit event, from one investor to another. swap premium paid periodically In a CDS, one party “sells” risk and the counterparty “buys” that risk. The “seller” of – who also tends to own the Payment only if credit event occurs underlying credit asset – pays a periodic fee to the risk “buyer.” In return, the risk “buyer” agrees to pay the “seller” a set amount if there is a default (technically, a credit event). CDS are designed to cover many risks, including: defaults, and downgrades. (For a more detailed list of CDS PROTECTION BUYER credit events see the Commonly Established CDS Credit Events table below). • Tends to own underlying credit asset • Purchasing credit protection The graphic below illustrates the credit default swap • credit exposure transaction between the risk “seller,” who is also the protection “buyer,” and the risk “buyer,” who is also the protection “seller.” Source: Credit Derivatives and Synthetic Structures, John Wiley & Sons. 2001 Credit Default Swaps

WHAT ARE THE CHARACTERISTICS OF CREDIT regulatory capital. Today, CDS have become the engine that DEFAULT SWAPS? drives the credit . The growth of the CDS The credit default swap market is generally divided into market is due largely to CDS’ flexibility as an active portfolio three sectors: management tool with the ability to customize exposure to corporate credit. Today the CDS market represents more than 1. Single-credit CDS referencing specific corporates, $10 trillion in gross notional exposure1. and sovereigns. In addition to hedging credit risk, the potential benefits of 2. Multi-credit CDS, which can reference a custom portfolio CDS include: of credits agreed upon by the buyer and seller, • Requiring only a limited outlay (which is significantly 3. CDS index. The credits referenced in a CDS are known as less than for cash bonds) “reference entities.” CDS range in from one to 10 years although the five-year CDS is the most frequently • Access to maturity exposures not available in the traded. cash market Credit default swaps provide a measure of protection against • Access to credit risk with limited rate risk previously agreed upon credit events. Below are the most • Investments in foreign credits without risk common credit events that trigger a payment from the risk • At times, more liquidity than investing in the underlying “buyer” to the risk “seller” in a CDS. cash bonds Commonly Established CDS Credit Events The performance of credit default swaps, like that of The reference entity becomes insolvent or is corporate bonds, is closely related to changes in credit unable to pay its spreads. This sensitivity makes them an effective tool for portfolio managers to or gain exposure to credit. Failure to Pay The reference entity fails to make interest or principal repayments when due Credit default swaps also allow for opportunities.

Debt Restructuring The configuration of obligations is changed in such a way that the credit holder is unfavorably affected GLOSSARY

Obligation The debt obligations of the issuer become due Credit/Default risk: The risk of loss of principal or loss of a financial Acceleration or before their originally scheduled maturity date reward stemming from a borrower’s failure to repay or otherwise meet a Obligation Default contractual obligation. Central Counterparty (CCP): A house that interposes itself Repudiation/ The issuer of the underlying bond (the between counterparties to contracts traded in one or more financial markets, Moratorium reference entity) rejects their debt, effectively becoming the buyer to every seller and the seller to every buyer and thereby refusing to pay interest and principal ensuring the future performance of open contracts.

Source: International Swaps and Derivatives Association Counterparty risk: The risk to each party of a contract that the counterparty will not live up to its contractual obligations. The terms of a CDS are determined when the CDS : Debt instrument issued by a private , as distinct contract is written. The most common type of CDS involves from one issued by a government or government agency. exchanging bonds for their , although the settlement : The differential between a corporate bond and an equivalent maturity sovereign bond. For example, if the 10-year Treasury note can also be in the form of a cash payment equal to the is trading at a yield of 3% and 10-year corporate bond is trading at a yield of difference between the bonds’ market value and par value. 4%, the credit spread if 1% or 100bps. Derivative: A which derives its value from movements in an HOW HAS THE CREDIT DEFAULT SWAPS underlying security, such as , bonds, commodities, and interest rates. MARKET EVOLVED? risk: When interest rates rise, the market value of The CDS market was originally formed to provide banks securities (such as bonds) declines. Similarly, when interest rates decline, the with the means to transfer credit exposure and free up market value of fixed income securities increases.

1 As of 30 June 2016. Source: BIS Past performance is not a guarantee or a reliable indicator of future results. Newport Beach Headquarters 650 Newport Center Drive Investing in the is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity Newport Beach, CA 92660 risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies +1 949.720.6000 with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price . Bond investments may be worth more or less than the original cost when redeemed. Derivatives may involve certain costs and risks, such as liquidity, interest Hong Kong rate, market, credit, management and the risk that a could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Credit default swap (CDS) is an over-the-counter (OTC) London agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used instrument. Milan There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors Munich and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. New York

This material has been distributed for informational purposes only and should not be considered as investment advice or a Rio de Janeiro recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Singapore

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