Electronic copy available at: http://ssrn.com/abstract=1555118
Coleman
December 2009
1
A PRIMER ON CREDIT DEFAULT SWAPS (CDS)
Thomas S. Coleman, PhD
Close Mountain Advisors LLC
tcoleman@closemountain.com
21 October 2008, updated 23 March 2009,
29 December 2009 (to include pricing)
INTRODUCTION
The market for Credit Default Swaps (CDS) has grown from nothing just over ten years ago to a huge
market today. But what is a CDS? How does a CDS behave in response to changes in the markets?
How does one value a CDS? What is the risk? This primer aims to answer these questions for plain-
vanilla single-name CDS.
Although CDS are often portrayed as complex, mysterious, even malevolent, they are really no more
complex or mysterious than a corporate bond. I show how and why a CDS behaves, in almost all
respects, as a leveraged or financed floating-rate corporate bond. The equivalence between a CDS
and a floating-rate bond is very useful because it means that anyone acquainted with corporate bonds,
anyone who understands how and why they behave in the market as they do, how they are valued, and
what their risks are, understands the most important aspects of a CDS. In essence, a CDS is no harder
(and no easier) to value or understand than the underlying corporate bond. I also point out the
particular ways in which a CDS differs from a corporate bond.
To preview the main points:
• Selling protection through a CDS is equivalent to buying a floating-rate corporate bond (a floating
rate note or FRN) using leverage.
− Selling protection for x years is in most respects the same as being long a corporate bond with
x years to maturity.
− The exposure to credit spreads is the same whether one sells CDS protection or buys an FRN.
In other words, when credit spreads move or upon default one can lose as much, but no more,
through selling $100 worth of CDS protection as buying $100 worth of a corporate FRN with
the same maturity and underlying credit.
• Conversely, buying protectio