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Swaps & NDF
Credit Default Swaps
Learning Outcome
5
Analyze CDS for hedging and credit risk transfer.
4
Calculate CDS premiums and identify influencing factors.
3
Explain Spread, Tenor, and Credit Events.
2
Identify buyer and seller roles.
1
Understand CDS for credit risk management.
What is a Credit Default Swap?
A Credit Default Swap (CDS) is a deal between two parties:
Party A (Protection Buyer)
fears that a company might default on its debt.
Party B (Protection Seller)
is willing to take on that risk for a fee.
- Party A pays Party B a regular fee called the CDS spread.
- In return, if the company defaults, Party B compensates Party A for the loss.
The key point: the actual bond or loan does NOT change hands. CDS is a pure risk transfer tool.
What Does a CDS Contract Contain?
Every CDS contract has these key terms:
Reference Entity
The company or government whose debt is being protected (e.g., Tata Power, Adani Ports)
Notional Amount
The size of the protection (e.g., ₹100 Crore) — used only for calculating payments
CDS Spread
The size of the protection (e.g., ₹100 Crore) — used only for calculating payments
Total Return Concept
In direct equity ownership, your return = price change + dividends.
Think of it this way: If you own a Nifty 50 stock, your return isn't just the price going up. It also includes any dividends the company paid you. That combined return is the "total return."
In an equity swap, the Total Return Payer passes both to the Receiver
Example — Infosys stock, 90-day swap, Notional ₹1 crore
The Receiver gets ₹6,40,000 — not just ₹5,00,000.
What if the price fell?
If Infosys dropped to ₹1,425 (−5%), the capital gain becomes −₹5,00,000. Add the ₹1,40,000 dividend.
Total Return = −₹3,60,000 → the Receiver now pays this to the Payer.
Payment Structure
Equity swaps settle periodically (monthly, quarterly) on a net cash basis. Here is how the structure works:
Real world example
📰 FINANCIAL EXPRESS
November 2023 | Business Standard
LIC Uses Equity Swap to Hedge Portfolio Without Selling Shares
To reduce equity market exposure before Q3 uncertainty, LIC structured a 3-month total return swap as Payer on its bluechip basket — effectively going short synthetically. If markets fell, the swap gains offset portfolio losses. No shares were sold.
Meaning
Application: Portfolio Hedging
An institution can hedge its shares by paying the stock return and receiving a fixed interest rate. If share prices fall, swap gains help offset losses without selling the shares.
Summary
5
Used for market exposure and hedging.
4
Only the net payment is settled.
3
Total return includes price changes and dividends.
2
Only cash flows are exchanged.
1
Equity swaps exchange equity returns for interest payments.
Quiz
In an equity swap, the total return includes:
A. Only dividends
B. Only capital gains
C. Capital gains/losses plus dividends
D. Interest payments only
Quiz-Answer
In an equity swap, the total return includes:
A. Only dividends
B. Only capital gains
C. Capital gains/losses plus dividends
D. Interest payments only
Swaps & NDF - Credit Default Swaps
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