Kartik Sharma's  Instablog

The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of CITI is 60 basis points or 0.6% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from JP Morgan Bank must pay the bank $60,000 per year. These payments continue until either the CDS contract expires or CITI defaults.

Ceteris paribus, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening in case of a credit event being triggered.

The CDS market is largely unregulated though now some measures are being taken by the Govt. to introduce some structured reforms in the same. Insider Information is governing the CDS spreads and often a movement on CDS spreads can be seen before a public information/announcement is made by a firm. CDS spreads are closely related with the credit rating announcement (Moody’s ratings) and are an authentic indicator of default probability of a firm on its underlying debts.

When a CDS event is triggered, it generally moves the equity of the company. Most of the time, Corporate Debt Restructuring is not a CDS trigger but even in a debt restructure case, equity may move up. Most of the time equity markets are subject to a lot of vagaries apart from what happens to the company. So equity can’t be a good measure of investor confidence and hence, Bond holder confidence is more suited to investor confidence.Because CDS have shown the ability to identify what financial institutions (or countries) are going to get into trouble next. When the market starts getting nervous about a company and thinks it is more likely to default, insurance on that company’s debt starts getting more expensive. This truly captues the essence of the investor sentiments/confidence driving the equity and at times even dominating the well established market fundamentals.

 "Disclosure - No Positions"