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:
CDS Spread
The annual fee paid by the buyer, quoted in basis points (bps)
Notional Amount
The size of the protection (e.g., ₹100 Crore) — used only for calculating payments
Reference Entity
The company or government whose debt is being protected (e.g., Tata Power, Adani Ports)
Tenor
How long the CDS lasts — usually 1, 3, or 5 years
Credit Events
The conditions that trigger the seller's payout obligation
Settlement
How the payout is made — physically (bond delivery) or in cash
Buyer and Seller Roles
The two CDS parties have opposite roles, transferring credit risk through distinct responsibilities and obligations.
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
