FRM Handbook Ch 23: Credit Derivatives and Structured Products (Credit Default Swaps)

Book: Financial Risk Manager Handbook Plus Test Bank
Author: Philippe Jorion
ISBN: 978-0-470-90401-5

Credit derivatives sound exotic until you realize you already trade them wearing different names. A corporate bond is a risk-free bond plus a short CDS position. Chapter 23 explains why the market exploded, what a CDS actually is, and where the plumbing gets messy.

Why credit derivatives exist

Banks want diversified loan books but their edge is relationship lending in local markets. Selling loans outright can upset clients. Buying protection via CDS lets them hedge without unloading the loan.

Bond insurance, letters of credit, and callable corporate debt all embed credit optionality. CDS made that risk transparent and tradable. You can go long or short credit without fighting the bond repo market.

The market grew from tens of billions of notional in the mid-1990s to tens of trillions by 2007. Most trading is OTC. Gross numbers overstated true risk transfer because dealers layered offsetting trades without tearing up old ones. Fitch estimated gross-to-net near 50:1, so net exposure was a small fraction of headline notional.

Post-crisis portfolio compression canceled redundant trades. Notional fell for the first time in 2008. By 2009 outstanding CDS was around $30 trillion, still huge but saner on paperwork and operational risk.

Anatomy of a credit default swap

Protection buyer pays premium (usually quarterly). Protection seller pays if a credit event hits the reference entity.

It is really a credit option with installments instead of upfront premium. Pay everything up front and people call it a default put.

CDS spread quotes annual cost in basis points. Distressed names trade up front. Washington Mutual was quoted 44 points up front plus 500bp running on September 17, 2008. Ten days later it triggered payment.

Settlement

Credit events follow ISDA definitions from Chapter 20. Settlement forms:

• Cash: pay par minus post-default market value of reference debt.
• Physical: deliver eligible bonds, receive par.
• Fixed recovery: pay (1 − assumed recovery) × notional without hunting for bonds.

Binary CDS pays a fixed amount on default. Combine binary and standard CDS and you can back out implied recovery.

Physical settlement lists deliverable obligations. Cheapest-to-deliver dynamics matter. A protection buyer may deliver the worst eligible bond.

Pricing intuition

CDS spread reflects risk-neutral PD and LGD, plus premia. Same decomposition as bond spreads. In equilibrium, CDS and cash bond spreads should be loosely linked, minus basis effects (delivery option, funding, counterparty risk in the swap itself).

Buying a risky bond at $90 that pays $100 in one year is equivalent to buying a risk-free bond at $95 and selling CDS worth $5 upfront. Same cash out, same default payoff.

Other credit derivatives (preview)

Section 23.3 covers total return swaps, credit spread forwards, and options. Section 23.4 and 23.5 go deep on structured products and CDOs in the next post in this series.

Market breakdown from surveys circa the handbook: roughly one-third single-name CDS, one-third index CDS, synthetic CDOs and tranche indices taking much of the rest.

Pros, cons, and regulation

Pros: transfer credit risk, short credit efficiently, fine-tune exposure by name or index.

Cons: counterparty risk in the derivative, legal uncertainty on credit events, operational backlog when gross trades pile up, complexity in structured leverage built on CDS (ABX, CDO-squared, etc.).

Regulators pushed central clearing and higher standards for collateral on OTC credit trades after the crisis.

What stuck with me

CDS are not magic risk evaporators. They move risk to someone else, who may be weakly capitalized. Gross notional is a storytelling number. Net and collateralized exposure is what matters.

And the equivalence to bonds is the key exam insight: long credit = short put on survival. Once that clicks, pricing and risk feel less mysterious.

Previous: FRM Handbook Ch 22: Credit Exposure (Exposure and Risk Modifiers)
Next: FRM Handbook Ch 23: Credit Derivatives and Structured Products (Structured Products and CDOs)