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Credit Default Swap (CDS), Ex: J.P Morgan Chase & Co. - Coggle Diagram
Credit Default Swap (CDS)
The most common type of credit derivative.
Involves two parties: a protection buyer and a protection seller.
The buyer pays periodic premiums to the seller in exchange for protection against the default of a specific reference entity (e.g., a corporation or a government).
If the reference entity defaults, the seller compensates the buyer for the loss.
Ex: J.P Morgan Chase & Co.
Key Components
Protection Buyer:
The party seeking to hedge against the credit risk of JPMorgan’s debt (e.g., bondholders, financial institutions).
Protection Seller:
The party assuming the credit risk in exchange for periodic premium payments (e.g., insurance companies, hedge funds).
Reference Entity:
JPMorgan Chase & Co., the company whose debt is being insured.
Notional Amount:
The face value of the debt being insured (e.g., $1 billion).
Premium Payments:
Regular payments made by the protection buyer to the protection seller.
Example: 2% annual premium on $1 billion, paid quarterly.
Credit Event:
Specific events triggering a payout, such as:
Bankruptcy
Failure to pay principal or interest
Restructuring of debt.
Settlement:
Mechanism for payout:
Physical Settlement: Buyer delivers the defaulted bond, and the seller pays face value.
Cash Settlement: Seller pays the difference between the bond’s face value and its market recovery value.
Structure the Terms
Premium Structure:
Typically calculated as a percentage of the notional amount.
Paid quarterly or annually by the protection buyer.
Credit Event Details:
Defined under ISDA agreements, includes:
Failure to pay interest or principal.
Bond restructuring with reduced payments.
Bankruptcy of the reference entity.
Settlement Mechanism:
Physical Settlement: Buyer delivers bonds in default, seller pays face value.
Cash Settlement: Seller compensates the buyer for the loss in bond value.
Regulatory Framework:
Governed by the International Swaps and Derivatives Association (ISDA).
Ensures standardization of terms and processes globally.
Market Dynamics and Risk Considerations
Current CDS Data:
Reflects the cost of insuring JPMorgan’s debt.
CDS spread acts as a barometer of JPMorgan’s perceived credit risk.
Historical Data:
Indicates market trends and reactions to economic events.
Tracks changes in JPMorgan’s CDS spreads over time.
Systemic Risk:
Large positions in CDS can destabilize markets.
Example: “London Whale” incident in 2012, where outsized CDS trading led to $6 billion in losses for JPMorgan.
Real-World Application
Case Study: London Whale Incident:
In 2012, JPMorgan faced significant trading losses due to outsized positions in CDS.
Losses totaled $6 billion and raised concerns about the role of derivatives in systemic risk.
Practical Hedging:
CDS are used to:
Protect against default risk.
Speculate on the creditworthiness of JPMorgan or other entities.
Indian Market Context
Regulatory Context:
Governed by the Reserve Bank of India (RBI) under Credit Derivatives Directions (2022).
Only certain entities (e.g., banks, insurers) can trade CDS in India.
Market Liquidity:
CDS market in India is still nascent with limited adoption.
Lack of active trading makes pricing and liquidity challenging.
Opportunities:
Growing corporate bond markets.
Increased demand for credit risk hedging due to Insolvency and Bankruptcy Code (IBC).
Potential for wider adoption as the financial ecosystem matures.