CDS: Forwards and Options

Extending the CDS Toolkit

While a standard Credit Default Swap (CDS) provides ongoing protection against default in exchange for a premium, CDS Forwards and CDS Options offer more flexibility in managing credit risk and expressing specific views on creditworthiness. A. CDS Forwards:

• What it is: An agreement to enter into a standard CDS contract at a specified future date at a predetermined CDS spread (the forward CDS spread). It's like locking in a future price for credit insurance.

• Key Features:

  • Deferred Start Date: The CDS contract doesn't begin immediately.
  • Predetermined Spread: The forward CDS spread is agreed upon today, but the actual CDS contract is only initiated in the future.
  • No Upfront Premium: Unlike a standard CDS, there is typically no upfront premium paid when entering into a CDS forward. Instead, the value of the forward contract is settled in cash at the initiation date.

• Purpose:

  • Hedging Future Credit Risk: If you anticipate needing credit protection in the future (e.g., you plan to invest in a corporate bond in six months), you can use a CDS forward to lock in the CDS spread today.
  • Speculating on Changes in CDS Spreads: If you believe that CDS spreads will widen (creditworthiness will deteriorate) in the future, you can buy a CDS forward. If you believe CDS spreads will narrow (creditworthiness will improve), you can sell a CDS forward.

• Valuation:

  • The value of a CDS forward is the present value of the difference between the forward CDS spread and the CDS spread that is actually prevailing at the future start date.

  Formula (Simplified):

  Forward Value = PV of (Future CDS Spread - Forward CDS Spread) * Notional Principal

  Where PV is the present value, discounted to today.

B. CDS Options (Credit Default Options):

• What it is: An option that gives the buyer the right, but not the obligation, to buy or sell credit protection (i.e., enter into a CDS contract) at a specified strike spread on or before a specified expiration date.
• Types:
  • CDS Call Option: Gives the buyer the right to buy credit protection (pay the CDS spread) if the actual CDS spread is higher than the strike spread at expiration. The buyer profits if creditworthiness deteriorates.
  • CDS Put Option: Gives the buyer the right to sell credit protection (receive the CDS spread) if the actual CDS spread is lower than the strike spread at expiration. The buyer profits if creditworthiness improves.
• Key Features:
  • Strike Spread: The predetermined CDS spread at which the option can be exercised.
  • Expiration Date: The date on which the option expires.
  • Premium: The price paid by the option buyer to the option seller.
• Purpose:
  • Hedging Contingent Credit Risk: If you have a potential future exposure to credit risk (e.g., you are bidding on a project that will require you to lend money to a company), you can use a CDS option to hedge that risk.
  • Speculating on Volatility of CDS Spreads: CDS options allow you to bet on the magnitude of changes in CDS spreads, regardless of the direction. If you expect CDS spreads to become more volatile, you can buy a CDS straddle (a call and a put with the same strike spread and expiration date).
• Payoff (at Expiration):
  • CDS Call Option: Max (0, Actual CDS Spread - Strike Spread) * Notional Principal
  • CDS Put Option: Max (0, Strike Spread - Actual CDS Spread) * Notional Principal
• Valuation:
  • CDS options are typically valued using models that are similar to those used for valuing standard options (e.g., Black-Scholes), but with adjustments to account for the specific characteristics of CDS spreads. These models require inputs such as the current CDS spread, the strike spread, the time to expiration, the volatility of CDS spreads, and the risk-free interest rate.

Key Differences and Advantages:

Why Use CDS Forwards and Options?

• More Flexible Risk Management: CDS forwards and options offer more flexible ways to manage credit risk than standard CDS.
• Express Specific Views: They allow you to express specific views on the future direction and volatility of CDS spreads.
• Tailored Hedging: They can be tailored to hedge specific credit risk exposures.