With several, formerly mighty investment giants having fallen in recent days and weeks, a great deal of interest has been generated in the credit-default swap (CDS) market, which is a common denominator in these banks’ business dealings.

Just as options are derivatives of their underlying stocks, credit-default swaps also fall under the “derivatives” umbrella. Just like you can use put options to “insure” your portfolio, investors use the CDS market to spend a small amount of money for the possibility of making a large amount of cash if a company performed poorly.

HOW DO SWAPS WORK?

A credit-default swap is a credit derivative between two parties, whereby one makes periodic payments to the other and receives the promise of a payoff if a third party defaults.

The former party receives credit protection and is said to be the “buyer” while the other party provides credit protection and is said to be the “seller.” The third party is known as the “reference entity.”

A simpler way to think of it is to compare it to an insurance policy you might buy to protect your home or your car. You pay the insurance company premiums over the life of the policy and, if something happens, the insurance company pays to fix or replace whatever was insured.

Credit default swaps were first traded in the Interbank market in 1997 but have grown rapidly since, with national volume of $62.2 trillion in 2007 — that’s up 81% from $34.50 in 2006.

What started out as a plain-vanilla market on single-company names now includes indexes, baskets, constant maturity and recovery swaps that all add to the liquidity in the marketplace.

The price movements in the CDS markets reflect the participant’s opinion on the financial health of a company. This is similar to corporate debt in that wider spreads are associated with weaker credits. It is different than corporate bonds in that the CDS market is not subject to the same liquidity constraints.

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A GAME OF RISK

More-mature companies issue debt, as the various rating agencies require an operating history and capital structure in order to rate the debt to be issued. While not every corporation that issues debt is quoted in the CDS market, every firm in the CDS market has issued debt and equity.

Debt issued by the U.S. government is considered to be the highest credit quality in the U.S. capital markets and is considered to be “risk free” when analyzing the probability of default at any given maturity.

All other debt that’s issued is considered to be of less credit quality and trades at a higher yield than U.S. government debt. The lower the rating, the higher the yield.

In other words, the more perceived risk in owning a specific credit, the more the investor wants to be compensated. The difference between the yield of the U.S. Treasury for a specific maturity and the yield of an individual corporate bond for the same maturity is known as the “Spread off of Treasuries.”

Individual corporate bonds don’t always accurately reflect the correct “spread” because a specific bond might be illiquid and trade at a lower spread than would otherwise be the case.

QUALITY CONTROL

Prices in the CDS market are another way of looking at the credit quality of an individual issuer. More-risky credits trade at higher prices.

Credit-default swaps are considered a better indicator of the credit quality of an individual issuer because they are more liquid and not subject to the same constraints as individual corporate bonds.

Analyzing the historical relationship between the CDS spread of a company and its share price can give valuable information on how a move in one affects the price of the other.

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The relationship between CDS spread and underlying share price is different for each company and may vary over time.

The chart below illustrates the relationship of various credit ratings to the U.S. Treasury debt of the same maturity.

USING CREDIT-DEFAULT SWAPS TO PROFIT

Although much has been written about the CDS market there are some very simple ways investors can use price information from that market, but it’s important to note that CDS levels and equity prices move in opposite directions (what’s known as ceteris paribus).

Further, the direction and rate of movement are more important at that absolute level.

So, to benefit from this knowledge:

• Buy stocks (or buy call options on underlying stocks) whose CDS levels are moving lower.
• Sell or short stocks (or buy put options on underlying stocks) whose CDS levels are moving higher.

Understanding the principles behind the CDS market can help you make more money in the options markets.