Credit Default Swaps: How

Credit Risk Moves Between

Parties
Credit default swaps are sophisticated financial contracts that form the
backbone of a $10+ trillion global market. These powerful instruments allow
banks and financial institutions to transfer the risk of loan defaults between
parties, effectively redistributing credit exposure across the financial system.

Emerging in the 1990s as specialized tools, they rapidly evolved into essential
risk management instruments used by major banks, hedge funds, and
institutional investors worldwide. Their pivotal role in the 2008 financial
crisis brought them under intense public scrutiny, leading to sweeping
regulatory reforms that enhanced transparency and oversight in this critical
market.

by vikrant kelkar
Vikrant
 What is a Credit Default
Swap?
Bilateral Contract Protection
A sophisticated financial Mechanism
agreement between two Acts as a powerful risk
parties that efficiently management instrument,
transfers credit risk exposure providing targeted financial
when a borrower defaults on compensation if a specified
their underlying debt credit event occurs with the
obligations reference entity

Risk Transfer
Strategically shifts potential financial losses from the protection buyer
to the protection seller in exchange for structured premium payments
over the contract term

A credit default swap functions essentially as insurance on debt instruments.

The protection buyer makes regular, predetermined premium payments to
the protection seller, who assumes the underlying credit risk. In return, the
seller legally commits to compensate the buyer for specific losses if the
referenced entity experiences a qualifying credit event4including default,
bankruptcy, or debt restructuring.

Vikrant
 Basic Structure of a CDS
Contract Basics Key Components
Credit default swaps operate as precisely defined agreements Reference entity: The organization whose credit risk is being
between counterparties, following standardized templates transferred
established by the International Swaps and Derivatives Reference obligation: The specific debt instrument covered
Association (ISDA). This standardization ensures legal clarity by protection
and market consistency, facilitating efficient trading and risk
Notional amount: The principal value being protected
management.
Premium/spread: The periodic payment for protection,
expressed in basis points
Maturity date: The contract's expiration, typically 1-10 years

This structured framework enables precise risk transfer while establishing clear settlement conditions. Each element requires careful
definition to eliminate ambiguity in the event of default, ensuring that both protection buyers and sellers have certainty regarding
their contractual obligations and rights.

Vikrant 3
 How a CDS Works: The Basic Steps

Premium Payments Credit Monitoring Credit Event Settlement Process

Protection buyer remits Both parties continuously Determination Protection seller provides
periodic premium payments evaluate the reference Upon occurrence of a compensation to the buyer
(typically quarterly) entity's creditworthiness, predefined credit event according to the
calculated using the financial performance, and (default, bankruptcy, predetermined settlement
contractual spread applied potential default indicators restructuring), the methodology and valuation
to the notional amount protection mechanism process
activates

To illustrate the economics: with a spread of 100 basis points (1%) on a $10 million notional value, the protection buyer would remit
$25,000 quarterly ($100,000 annually distributed across four payment dates). These premium payments persist throughout the
contract's duration until either maturity is reached or a credit event triggers the settlement process.

Vikrant 4
 Key Features of Credit
Default Swaps
Synthetic Exposure
Access credit risk positions without owning underlying debt, facilitating
strategic capital allocation and expanding market participation beyond
traditional boundaries

Standardization
Harmonized documentation and consistent market terms dramatically
improve trading efficiency, enhance liquidity, and create more
transparent price discovery mechanisms

Secondary Market
Actively trade positions prior to maturity to leverage market movements,
dynamically adjust portfolio risk profiles, or capture value without
holding contracts to expiration

Flexible Terms
Customize protection periods (predominantly 1-10 years) with
standardized quarterly payment dates to align precisely with specific
institutional risk management requirements

These sophisticated features have established CDS instruments as the

foundation of modern credit risk transfer, enabling precise risk calibration
and strategic exposure management across the global financial ecosystem.

Vikrant
 How Credit Risk Transfer Works
Isolation of Credit Risk
Targeted Protection
Separating default risk from underlying
Acquiring specific safeguards against
assets to create independently tradable
defined credit events while maintaining
instruments that can be priced and
existing portfolio positions and
managed distinctly from the original
preserving core investment strategies
investments

Portfolio Diversification
Strategic Risk Transfer
Reducing concentrated exposures by
Shifting credit exposure to
strategically distributing credit risk
counterparties with enhanced risk-
across multiple sectors, entities, and
bearing capacity, specialized expertise,
geographies to optimize risk-adjusted
or complementary portfolio objectives
returns

Credit default swaps function as sophisticated risk transmission mechanisms that enable precise reallocation of credit exposure
between market participants. This innovative structure allows banks, asset managers, insurance companies, and corporations to fine-
tune their risk profiles with unprecedented granularity and efficiency compared to conventional approaches of directly trading the
underlying debt obligations themselves.

Vikrant 6
 Real Example of CDS in USA: AIG's Near-Collapse
(2008)
Market Dominance
AIG sold $527 billion in CDS protection on mortgage-backed securities

Housing Market Crash

Widespread mortgage defaults triggered massive payment obligations

Cash Shortage
AIG faced an $85 billion liquidity crisis with insufficient reserves

Government Rescue
Historic $182 billion bailout prevented systemic financial
collapse

AIG's aggressive selling of credit default swaps on mortgage-backed securities without maintaining adequate capital reserves created a
textbook case of concentrated risk. When the housing market collapsed in 2008, AIG found itself unable to meet its contractual
obligations, threatening to trigger a devastating chain reaction throughout interconnected global markets. The unprecedented
government intervention underscores how credit derivatives, when improperly managed, can transform isolated market weaknesses
into existential threats to the entire financial system4a cautionary tale that fundamentally reshaped regulatory approaches to
systemic risk.

Vikrant 7
CDS in India: The IL&FS
Case (2018)
Size of Company
IL&FS managed a colossal ¹91,000 crore debt portfolio across
169 subsidiary entities

Failed Payments
In September 2018, IL&FS defaulted on multiple payment
obligations, triggering a liquidity crisis that reverberated
throughout India's financial markets

Effects on Market
Credit default swap premiums for Indian banks skyrocketed by
50-80 basis points as investors scrambled to hedge exposure

Government Steps
The Indian government swiftly intervened, seized control, and
implemented a comprehensive restructuring plan to contain
systemic damage

Despite India's nascent domestic CDS market at the time, international CDS
contracts served as crucial warning signals, revealing mounting concerns
about Indian financial institutions. Foreign investors holding IL&FS debt
frantically purchased credit protection as CDS premiums soared to
unprecedented levels. This watershed crisis ultimately became a catalyst for
sweeping regulatory reforms to strengthen India's local CDS market
infrastructure and fortify the financial system against future systemic shocks.

8
 Key Participants in Credit Default Swap
Transactions
Protection Buyer Protection Seller
Purchases protection against credit default Assumes credit default risk in exchange for
risk exposure premium income

Pays recurring premium payments Commits to deliver compensation if

throughout contract duration specified credit events occur

Regulatory Bodies Reference Entity

CFTC in US, SEBI in India establish Corporation or sovereign whose debt
oversight frameworks obligations underlie the contract

Enforce transparency, reporting Typically has no direct involvement in the

requirements, and capital standards CDS agreement itself

Credit Default Swap transactions function through a precisely defined relationship between protection buyers and sellers who
transfer credit risk related to a reference entity's debt obligations. The reference entity4whose default would trigger settlement
payments4generally remains uninvolved in and often unaware of these transactions. Market intermediaries such as investment
banks and specialized dealers provide essential infrastructure by facilitating execution, offering market-making services, and
supporting price discovery in this sophisticated credit risk transfer ecosystem.

Vikrant 9
The Protection Buyer
Risk Management Focus
Strategically acquires protection against default risk exposure on
credit investments and loans

Short Credit Position

Captures financial advantage when credit quality deteriorates or credit
spreads widen in the market

Institutional Profile
Predominantly comprises commercial banks, sophisticated asset
managers, and corporate treasury departments

Usage Strategies
Leverages CDS contracts for portfolio hedging, directional market
positioning, and regulatory capital optimization

Protection buyers encompass a diverse range of financial institutions4from

banks safeguarding extensive loan portfolios and asset managers protecting
bond investments to specialized hedge funds anticipating credit
deterioration. These market participants deploy credit default swaps as
sophisticated risk management instruments to offset potential losses from
defaults or credit rating downgrades, while simultaneously creating
opportunities to capitalize strategically when reference entities experience
declining creditworthiness.

10
 The Protection Seller
Insurance Companies
Utilize their advanced risk assessment capabilities and substantial capital
reserves to generate premium-based revenue streams through CDS
contracts. These firms integrate credit risk within their diversified risk
portfolios, applying established actuarial methodologies to this specialized
market segment.

Pension Funds
Enhance yields on long-term investment portfolios by strategically
assuming calculated credit risk positions. This approach becomes
especially valuable during periods of compressed interest rates when
conventional fixed-income investments deliver suboptimal returns.

Hedge Funds
Construct strategic positions by selling protection based on sophisticated
proprietary credit analysis. These institutions often employ controlled
leverage to maximize potential returns while implementing complex
hedging strategies to effectively manage exposure across various market
conditions.

Protection sellers fundamentally profit from credit stability, earning consistent premium income in scenarios where defaults don't
occur. This market role requires exceptional financial strength, advanced quantitative risk modeling capabilities, and meticulous risk
management frameworks to withstand potentially significant losses should reference entities default on their underlying obligations.

Vikrant 11
 Reference Entity: The Borrower Behind the CDS
Who They Are
Corporations, sovereign nations, municipal governments, or financial institutions that have issued debt
instruments

Legal Status
Legally defined entity with outstanding debt obligations that can be referenced in
credit derivative contracts

Outside Position
Not directly involved or party to CDS contracts referencing
their own debt, despite being central to the agreement

The perceived default risk of a reference entity directly determines CDS pricing4entities viewed as higher credit risks command
significantly higher premium payments from protection buyers. Notably, the CDS market often features protection volumes that
substantially exceed the underlying debt value, a phenomenon dramatically illustrated during major credit events such as the 2008
Lehman Brothers collapse.

For sophisticated market participants, CDS spreads function as crucial forward-looking indicators of market sentiment regarding an
entity's creditworthiness. These spreads frequently signal potential financial distress well before formal credit rating downgrades or
public financial disclosures materialize, providing valuable early warning signals for investors.

Vikrant 12
 Reference Obligation: The Specified Debt
Contractual Cornerstone Settlement Functions
The reference obligation constitutes the specific debt Establishes the definitive benchmark for cash settlement
instrument explicitly designated in the CDS contract. Typically a valuations
senior unsecured bond or occasionally a loan, this obligation Functions as the primary deliverable security in physical
precisely defines the scope of protection and serves as the legal settlement scenarios
foundation for the entire agreement. This designation
Determines the seniority hierarchy for all covered
eliminates ambiguity about which obligations fall under the
obligations
contract's protection.
Sets comprehensive eligibility parameters for alternative
deliverable obligations

Although the contract identifies one specific reference obligation, CDS protection typically extends to all pari passu debt instruments
(those with equivalent seniority). This critical flexibility provides the protection buyer with enhanced optionality during physical
settlement, permitting the delivery of any qualifying debt instrument that satisfies the contractually stipulated characteristics and
priority ranking within the capital structure.

Vikrant 13
 Premium Payments: The CDS Spread
1,200

800

400

0
AAA AA A BBB BB B CCC

The CDS spread represents the premium that protection buyers must pay, expressed in basis points per annum of the notional
amount. For example, a 100-basis-point spread means the buyer pays 1% of the contract's total value annually. These payments
typically occur quarterly on standardized industry dates (March 20, June 20, September 20, and December 20), enhancing market
liquidity and facilitating efficient settlement operations across the derivatives market.

CDS spreads function as market-determined prices that reflect three critical factors: probability of default, expected recovery rates,
and market supply-demand dynamics. When spreads widen, they signal heightened perception of credit risk, while narrowing
spreads indicate improved creditworthiness. This responsive relationship makes CDS spreads particularly valuable as real-time
indicators of market sentiment toward credit quality, often reacting to changes in financial conditions well before traditional rating
agencies update their formal assessments. Risk managers, traders, and portfolio managers vigilantly monitor these spreads as leading
indicators of evolving default risk and potential investment opportunities.

Vikrant 14
 Credit Event Triggers: Bankruptcy
Legal Filing
Formal bankruptcy declaration immediately triggers CDS protection with no waiting period required

Definitive Evidence
Court-documented bankruptcy proceedings provide unambiguous verification of the credit event

Expedited Resolution
CDS settlement proceeds more rapidly following bankruptcy than with other credit event types

Bankruptcy constitutes the most unequivocal trigger for credit default swaps (CDS). When an entity files for bankruptcy protection,
this legal action represents an irrefutable acknowledgment of its inability to meet debt obligations, instantly activating the CDS
contract. The formal court documentation provides incontestable evidence of the credit event, eliminating ambiguity in the
settlement process.

For CDS contracts to be properly triggered, the bankruptcy filing must specifically involve the reference entity named in the
agreement, not merely affiliated companies or subsidiaries, unless these related entities are explicitly specified in the contract terms.
The CDS protection becomes effective regardless of whether the bankruptcy involves Chapter 7 liquidation or Chapter 11
reorganization under court supervision, providing comprehensive protection to the buyer.

Vikrant 15
 Credit Event Triggers: Failure to Pay

Credit Event Declared

Materiality Threshold ISDA Determinations
Grace Period Expires Met Committee officially confirms
Payment Default Default continues beyond the Missed payment surpasses the the failure-to-pay event,
Occurs specified grace period predetermined minimum activating the CDS settlement
Entity misses a scheduled debt (typically 3-30 days), threshold (commonly $1 protocol.
payment, initiating the confirming it's not merely a million), establishing the
contractual grace period temporary processing delay. default's financial
countdown. significance.

Failure to pay constitutes a fundamental credit event trigger that indicates significant financial distress prior to formal bankruptcy
proceedings. This trigger effectively identifies when an entity faces substantial liquidity challenges while remaining technically
solvent. The dual safeguards of grace periods and materiality thresholds work in tandem to distinguish legitimate financial difficulties
from administrative delays or inconsequential technical issues, ensuring only meaningful defaults trigger CDS protection.

Vikrant 16
 Credit Event Triggers: Restructuring
Full Restructuring (CR) Modified Restructuring (MR)
The most comprehensive trigger that captures all forms of Narrows deliverable obligations to bonds maturing within 30
debt restructuring. Prevalent in European and emerging months after either the restructuring date or CDS contract
markets, CR permits delivery of bonds with any maturity, expiration, whichever is later. This approach, favored in
while implementing sophisticated price adjustments to European financial markets, strikes a balance between
ensure fair valuation across the spectrum of obligations. flexibility and controlled exposure.

Modified-Modified Restructuring (MM) No Restructuring (XR)

A strategic middle-ground approach that extends deliverable Entirely eliminates restructuring as a qualifying credit event.
maturity limits to 60 months for restructured debt and 30 Established as the market standard for North American
months for other obligations. This nuanced framework corporate CDS contracts since 2009, this approach is
effectively reconciles the comprehensive nature of CR with particularly prevalent for entities with elevated credit risk
the more constrained parameters of MR. profiles where clearer default triggers are preferred.

Restructuring events encompass substantial modifications to debt terms such as maturity extensions, interest rate reductions,
principal reductions, or priority subordinations that materially disadvantage creditors. Among credit event triggers, restructuring
remains the most controversial due to the inherent challenge of distinguishing between legitimate distressed debt reorganizations
and routine corporate liability management activities.

Vikrant 17
 Settlement Methods: Physical Delivery

Credit Event Delivery Notice Bond Transfer Full Payment

Triggered by default, Protection buyer specifies Selected debt instruments Protection seller remits
bankruptcy, or material debt qualifying obligations for physically transferred to 100% of par value to the
restructuring settlement protection seller buyer

Physical settlement requires the protection buyer to deliver actual debt instruments issued by the reference entity to the protection
seller in exchange for the full face value of those obligations. Deliverable instruments must satisfy specific eligibility criteria: they
must maintain senior or equivalent priority ranking, be denominated in contractually permitted currencies, and possess a remaining
maturity not exceeding 30 years.

While physical settlement dominated the early credit derivatives market, it has been largely supplanted by cash settlement
mechanisms. This transition was necessitated by "delivery squeezes" that occurred during major credit events4scenarios where the
notional value of outstanding CDS contracts substantially exceeded the available supply of deliverable obligations, creating significant
market distortions and operational challenges for settlement processes.

Vikrant 18
 Example of Settlement through Physical
Delivery: Delphi Corporation
October 2005
Automotive parts supplier Delphi Corporation files for
Chapter 11 bankruptcy protection

CDS Trigger
ISDA formally declares bankruptcy as a credit event,
triggering approximately $28 billion in outstanding CDS
Bond Shortage contracts

Severe market imbalance emerges with only $2 billion

of actual Delphi bonds available for physical settlement
Market Distortion
Scarcity of deliverable bonds creates paradoxical price
increases despite the issuer's bankruptcy status

The Delphi case exposed a critical flaw in physical settlement mechanisms: when CDS notional values vastly exceed available
deliverable bonds, a "delivery squeeze" becomes inevitable. Protection buyers frantically competed to acquire Delphi bonds, driving
prices unexpectedly higher despite the bankruptcy4an outcome that contradicted fundamental economic principles.

This landmark case served as a catalyst for market evolution, accelerating the adoption of auction-based cash settlement protocols.
The auction mechanism, now standard across CDS markets, effectively eliminates the structural inefficiencies and price distortions
inherent in physical delivery requirements, ensuring more orderly and economically rational settlements.

Vikrant 19
 Settlement Methods: Cash Settlement

Payment Executed
Price Determined The protection seller
Auction Scheduled A transparent two-phase compensates the buyer for the
Credit Event ISDA announces and auction process establishes difference between par value
Confirmed coordinates a centralized, the final recovery value of the (100%) and the auction-
ISDA determination industry-wide auction to defaulted debt, expressed as a determined recovery value,
committee formally declares a establish the fair market value percentage of its face value finalizing the settlement.
credit event has occurred, of the reference entity's debt (par).
triggering the settlement obligations.
process for all affected
contracts.

Auction-based cash settlement has been the industry standard since 2005, resolving the structural inefficiencies of physical delivery
methods. This mechanism establishes a single, market-driven price for defaulted debt, ensuring equitable and consistent settlement
across all contracts referencing the same entity.

To illustrate: in a $10 million CDS contract where the auction determines a 20% recovery rate on the reference obligation, the
protection seller would pay the buyer $8 million (representing the 80% loss from par value). This standardized approach efficiently
handles settlement even when CDS notional values substantially exceed available deliverable bonds.

Vikrant 20
 Washington Mutual: A Cash Settlement
Example

$150B 57
CDS Total Value Auction Participants
Total protection linked to WaMu Major dealers determining settlement price

9.75% 90.25%
Recovery Rate Payout Percentage
Final auction-determined value Amount sellers paid to buyers

Washington Mutual's collapse in September 2008 represented the largest bank failure in U.S. history at that time, triggering an
unprecedented $150 billion in CDS settlements. Through ISDA's structured auction process, the recovery rate was established at a
strikingly low 9.75%, compelling sellers to compensate buyers with 90.25% of the contractual value4a catastrophic loss for protection
sellers.

This standardized auction mechanism successfully orchestrated settlements across hundreds of diverse counterparties,
demonstrating remarkable resilience even amid extreme financial market turbulence. The cash settlement approach effectively
prevented potentially devastating market disruptions that would have inevitably occurred under physical settlement, especially
considering the severe scarcity of deliverable bonds relative to the extraordinary volume of outstanding CDS contracts.

Vikrant 21
CDS Usage: Hedging
Applications

Loan Portfolio Bond Investment Counterparty

Protection Protection Risk
Banks leverage CDS to Investment managers Management
diversify concentrated deploy CDS Organizations utilize
credit exposures while strategically to shield CDS as a safeguard
preserving valuable against default risk and against potential
client relationships and protect their fixed defaults by critical
retaining existing loans income portfolios from trading partners,
on their books adverse market suppliers, and financial
movements intermediaries

Capital Relief
Financial institutions
expertly transfer credit
risk through CDS to
optimize regulatory
capital requirements
while maintaining
established customer
relationships

Hedging constitutes the cornerstone application that originally drove the

development of credit default swaps. Through these sophisticated
instruments, financial institutions precisely manage credit exposures and
shield themselves against potential losses within their portfolios. This elegant
risk transfer mechanism allows institutions to nurture strategic client
relationships while simultaneously reducing dangerous concentrations in
vulnerable sectors, geographic regions, or individual counterparties.

22
 CDS Usage: Trading and Arbitrage
Directional Credit Trading Relative Value Strategies
Sophisticated investors deploy CDS contracts to speculate on Basis trading (capitalizing on price disparities between
credit quality changes without the capital requirements of bond bonds and their corresponding CDS)
ownership. Traders anticipating deterioration can purchase Curve trading (strategically positioning across multiple CDS
protection, generating substantial returns if credit risk maturity points)
increases. Conversely, protection sellers express bullish credit
Capital structure arbitrage (establishing offsetting positions
views, earning consistent premium income when default events
between equity securities and CDS)
fail to materialize.
Index arbitrage (exploiting pricing inefficiencies between
indices and underlying constituent names)

The exceptional liquidity and versatility of CDS markets make them powerful tools for sophisticated speculation and alpha generation.
Leading hedge funds and institutional trading desks implement complex, quantitative strategies to identify and capture momentary
price inefficiencies while achieving more capital-efficient directional credit exposure than possible through traditional fixed-income
investments.

Vikrant 23
Advantages of Credit
Default Swaps
Enhanced Risk Management
Allows institutions and investors to transfer and hedge credit exposure
without liquidating underlying assets

Market Liquidity Improvement

Creates more efficient price discovery for credit risk, enhancing
market depth and transparency

Precise Risk Quantification

Delivers real-time, market-based assessments of default probabilities
that reflect collective investor insights

Customization Potential
Provides tailored exposure to specific entities across various
timeframes to match exact investment requirements

Credit default swaps distribute risk throughout the financial system, fostering
greater market resilience. They function as early warning indicators, often
signaling credit deterioration before formal rating downgrades occur.
Furthermore, these instruments enhance market efficiency by providing
sophisticated mechanisms for expressing negative credit views4creating an
essential counterbalance that promotes accurate price discovery and helps
prevent asset bubbles through more comprehensive valuation signals.

24
 Drawbacks and Concerns

Systemic Risk
Dangerous concentration of exposure among interconnected financial institutions

Counterparty Risk
2 Potential collapse of protection sellers during financial crises when payments are
most needed

Valuation Complexity
3 Inherent challenges in accurately pricing instruments with contingent
payment structures

Excessive Leverage
Facilitates accumulation of substantial risk positions with inadequate
capital safeguards

Reduced Due Diligence

Erodes incentives for thorough credit analysis when risks can
be easily transferred

Critics contend that credit default swaps create perilous interconnections throughout the financial system that become especially
vulnerable during market turbulence. The 2008 financial crisis vividly illustrated how AIG's extensive CDS portfolio threatened the
entire global financial architecture, necessitating unprecedented government intervention. Furthermore, when CDS notional values
significantly exceed the underlying debt instruments4often by multiples4they can generate severe market distortions and create
perverse incentive structures where participants may actually benefit from credit deterioration or defaults.

Vikrant 25
 US Market Example: Lehman Brothers CDS
Settlement (2008)

Unprecedented Scale Auction Process Regulatory Aftermath

Lehman's bankruptcy triggered The ISDA auction on October 10, 2008, While demonstrating operational
approximately $400 billion in CDS established Lehman's debt at a strikingly resilience, the Lehman settlement
settlements4the largest in market history. low 8.625% recovery rate. This required revealed dangerous risk concentrations
This massive volume raised profound CDS sellers to pay buyers 91.375% of the within the CDS market. This catalyzed
questions about the market contract value4a significantly higher comprehensive reforms including
infrastructure's capacity to withstand such payout than market participants had mandatory central clearing, dramatically
an extraordinary settlement process. projected, creating substantial losses for enhanced transparency through robust
protection sellers. reporting requirements, and substantially
more stringent capital standards for
market participants.

Despite pervasive concerns about the system's capacity to manage settlements of this magnitude, the CDS market performed with
remarkable efficiency throughout the Lehman crisis. The final net settlement amount was dramatically smaller than the gross
notional value due to the offsetting effect of countervailing positions, demonstrating the market's structural ability to absorb
significant shocks even during periods of extreme financial stress.

Vikrant 26
 US Market Example: GM and Ford CDS (2005)
1,200

800

400

0
Jan 2005 Mar 2005 May 2005 Jun 2005 Dec 2005
GM CDS Spread (bp) Ford CDS Spread (bp)

In May 2005, the credit derivatives market experienced a watershed moment when Standard & Poor's and Moody's downgraded
General Motors and Ford debt to non-investment grade ("junk") status. This triggered an extraordinary spike in their Credit Default
Swap (CDS) spreads, with GM's 5-year protection costs soaring to an unprecedented 1,200 basis points4effectively pricing in a 20%
probability of default within the five-year period. Remarkably, the CDS market had already begun signaling this heightened risk
several months before the official downgrades, with spreads widening significantly from January through March.

This pivotal market event revealed two critical insights for financial market participants: First, CDS markets function as sophisticated
early warning systems, identifying credit deterioration well before formal rating agency actions4demonstrating their value as leading
indicators of corporate financial health. Second, it exposed a dangerous structural vulnerability when numerous hedge funds
employing similar correlation-based trading strategies simultaneously attempted to exit positions during the market dislocation. The
resulting liquidity crunch magnified price volatility and propagated losses across the financial system, foreshadowing similar
dynamics that would emerge during the 2008 financial crisis.

Vikrant 27
 US Market Example: Sovereign CDS during
COVID-19

The COVID-19 pandemic unleashed unprecedented financial market volatility in March 2020, fundamentally reshaping credit risk
perceptions across global markets. US sovereign Credit Default Swap (CDS) spreads4instruments that measure the cost of insuring
against government debt default4spiked dramatically from their traditional stability around 5 basis points to over 25 basis points,
reflecting profound investor concern about rapidly deteriorating fiscal conditions amid massive emergency stimulus requirements.
Concurrently, the CDX Investment Grade index, which tracks default risk across major US corporations, experienced a staggering
fivefold increase from 50 to 280 basis points within a mere three-week period, signaling an acute crisis of confidence throughout the
entire credit ecosystem.

In response to this extraordinary market dislocation, the Federal Reserve implemented a series of bold, unprecedented intervention
strategies. Most notably, the Fed established corporate bond purchasing facilities4crossing a historic threshold never before
breached in its 107-year history. These decisive actions proved remarkably effective at calming market turbulence. By Q3 2020, credit
risk indicators had largely normalized toward pre-pandemic levels, illustrating both the contagious psychology of market panic and
the powerful stabilizing influence of targeted central bank intervention during systemic crises. This episode stands as a definitive case
study in how sovereign credit markets absorb and ultimately recover from global systemic shocks when supported by decisive policy
action.

Vikrant 28
 Indian Market: Development and Growth
2011
RBI establishes inaugural regulatory framework for
corporate bond CDS

2011-2020
Market remains underdeveloped due to restrictive
regulations
2022
RBI implements comprehensive regulatory reforms to
expand market access
2023-Present
Gradual expansion with market volume reaching
approximately ¹500 crore

India's Credit Default Swap market has evolved at a significantly slower pace than its global counterparts, primarily hampered by
conservative regulatory oversight and an underdeveloped corporate bond ecosystem. When first introduced in 2011, the regulatory
framework imposed substantial restrictions that effectively stifled growth4limiting participation exclusively to banks and primary
dealers while restricting CDS instruments to listed corporate bonds, which resulted in negligible trading volumes and market
stagnation.

The landmark 2022 regulatory overhaul represented a watershed moment in India's CDS market development. By extending market
access to a broader range of institutional investors4including insurance companies, mutual funds, and foreign portfolio investors4
while simultaneously maintaining a strategic focus on risk mitigation rather than speculative trading, the RBI struck a delicate
balance. These carefully calibrated reforms aim to catalyze market liquidity and depth while implementing robust safeguards
designed to prevent the systemic vulnerabilities that have plagued more mature CDS markets globally. This measured approach
reflects India's commitment to financial innovation tempered by prudential oversight.

Vikrant 29
 Indian Example: HDFC Bank CDS
Market Benchmark Foreign Investor Usage Market Indicator
HDFC Bank's CDS serves as the International investors holding HDFC HDFC CDS spreads widen notably
definitive benchmark for India's Bank bonds strategically employ CDS during banking sector turbulence or
financial sector credit risk. With contracts to hedge against both emerging market instability, serving
spreads typically ranging between 80- currency volatility and credit as a reliable early warning system for
120 basis points based on market deterioration without liquidating their India's financial infrastructure. These
conditions, it offers vital insights into positions. This sophisticated approach spreads peaked during two critical
systemic stability. As India's leading allows them to maintain exposure to periods: the 2013 "taper tantrum"
private banking institution, HDFC's India's strong growth prospects while when markets reacted to Federal
CDS effectively functions as a effectively mitigating downside risks Reserve policy shifts, and the
barometer for the overall health of the in their portfolios. unprecedented volatility during the
banking ecosystem. 2020 COVID-19 crisis.

Though traded exclusively in international markets rather than domestically, HDFC Bank CDS contracts provide a transparent window
into global investor perceptions of risk within India's financial landscape. The bank's strong credit fundamentals consistently result in
tighter spreads compared to most Indian corporations, establishing it as the benchmark for premium Indian credit risk assessment.

Vikrant 30
 Indian Example: Sovereign Risk Assessment
450

300

150

0
2019 2020 2021 2022 2023
India 5Y CDS (bp) EM Average (bp)

India's sovereign Credit Default Swap (CDS) contracts function as a definitive gauge of global investor confidence in India's economic
stability. Traded predominantly in international markets, these financial instruments provide precise quantification of perceived
sovereign risk. The data consistently reveals India's advantageous position, with CDS spreads significantly lower than broader
emerging market averages4a testament to India's superior economic fundamentals, sustained growth potential, and robust
institutional framework.

The COVID-19 pandemic created a stark illustration of this relationship, with India's CDS spreads surging to 280 basis points in March
2020 before steadily retreating as recovery gained momentum. Current spreads hover in the 80-150 basis point range, reflecting the
market's nuanced assessment: optimism regarding India's economic resilience balanced against pragmatic concerns about fiscal
constraints and inflationary pressures. This persistent spread differential versus emerging market peers underscores India's
distinctive strength in capturing global investment interest despite broader market volatility.

Vikrant 31
 Future Trends in CDS Markets
More Transparency
Implementation of comprehensive
Central Clearing disclosure frameworks providing
Accelerating transition toward granular visibility into pricing
centralized clearing platforms to mechanisms, trading volumes, and
mitigate counterparty risks, enhance institutional positioning across markets
market stability, and ensure regulatory
compliance ESG Focus
Proliferation of sophisticated credit
derivatives incorporating quantifiable
environmental, social, and governance
risk metrics with standardized
sustainability benchmarks
Growth in New Markets
Strategic expansion of CDS adoption Digital Tools
across diverse emerging economies, Strategic adoption of blockchain
with notable acceleration in high- infrastructure and smart contract
growth markets like India, Brazil, and
protocols to automate settlement
Southeast Asian nations
processes, enhance verification, and
substantially reduce operational
friction

The CDS market is undergoing a fundamental transformation driven by coordinated regulatory reforms and technological innovation.
Post-financial crisis regulatory frameworks have systematically addressed the structural vulnerabilities that previously amplified
systemic risk, while the standardization of contract specifications has dramatically improved market efficiency, price discovery, and
overall liquidity conditions.

Particularly noteworthy emerging developments include the sophisticated integration of sustainability metrics into credit risk
assessment, deployment of distributed ledger technologies to revolutionize transaction processing workflows, and the strategic
transition toward comprehensive central counterparty clearing mechanisms designed to mitigate interconnected exposures
throughout the global financial ecosystem.

Vikrant 32
 Key Pricing Factors
Default Risk
The statistical probability that a reference entity will default on its contractual debt obligations

Credit rating migration matrices and historical default correlation data

Real-time credit spread movements and forward-looking market indicators
Fundamental credit analysis incorporating both quantitative metrics and qualitative factors

Recovery Value
The anticipated percentage of notional value expected to be recouped following a credit event

Empirical recovery rates stratified by industry sector, jurisdiction, and debt seniority

Comprehensive evaluation of both tangible assets and enterprise value components

Market convention of 40% recovery assumption for senior unsecured obligations in developed markets

Interest Rates
Risk-free rate benchmarks used to derive present value calculations for contingent payment streams

Multi-tenor risk-free rate curves transitioning from LIBOR to alternative reference rates like SOFR
Credit-adjusted discount factors calibrated to issuer-specific funding costs
Basis risk between interest rate environments and systemic default probability factors

Market Liquidity
The premium demanded for imperfect market depth and execution certainty across various market conditions

Execution cost metrics including bid-offer differentials as proxies for market depth

Evolving supply-demand equilibrium among dealers, asset managers, and hedge funds
Basel III and other regulatory frameworks' impact on dealer inventory capacity and market-making commitment

CDS pricing methodology employs complex stochastic modeling techniques that synthesize multiple interdependent variables to
determine theoretically fair valuations. The foundation of precise pricing rests on calibrated default probability curves across the
temporal spectrum, combined with nuanced recovery assumptions tailored to specific default scenarios and jurisdictional
frameworks.

Vikrant 33
 Conclusion: The Role of CDS in Modern Finance

Risk Management Tool Market Challenge Future Direction

Credit default swaps enable institutions to The evolution of CDS markets has revealed Market maturation has catalyzed greater
precisely manage credit exposure while both their potential and limitations. Their standardization, transparency, and
maintaining valuable client relationships. controversial role in the 2008 financial accessibility in CDS contracts. Emerging
They facilitate targeted risk mitigation crisis underscored the critical need for economies are systematically developing
strategies tailored to specific profiles and enhanced transparency, robust domestic CDS markets by incorporating
requirements. When properly collateralization practices, and centralized lessons from established markets. This
implemented, CDS instruments regulatory supervision. Subsequent measured approach thoughtfully balances
strengthen the financial ecosystem by reforms have successfully addressed many financial innovation with necessary
efficiently distributing risk across diverse of these structural vulnerabilities while prudential safeguards to ensure
market participants with complementary preserving the instrument's fundamental sustainable market development.
risk appetites. utility.

Credit default swaps represent sophisticated risk transfer mechanisms that, like other complex derivatives, demand disciplined
implementation and comprehensive oversight. Their unique ability to isolate and distribute credit risk delivers substantial market
efficiencies when deployed within robust risk management frameworks. The market continues to evolve through enhanced
standardization, improved transparency, and expanded central clearing4effectively addressing vulnerabilities while preserving the
vital functions these instruments serve in modern financial markets.

Vikrant 34