The CDS Payout Ratio is the proportion of the insured amount that the holder of the credit default swap is paid by the seller of the swap if the underlying asset defaults.
How It Works
Suppose an investor holds €10,000,000 worth of 5-year Spanish government bonds. The bonds pay a coupon interest of 5% per annum. The investor is worried about his exposure (suppose there is a recession in Spain) and buys credit default swaps for his bonds from a bank. The CDS requires an upfront premium of 2% and yearly premiums of 1% of the insured amount (€10,000,000).
Therefore, the investor pays €200,000 upfront to the bank and pays €100,000 a year for the next 5 years (duration of the bonds). Suppose there is a major financial scandal in Spain, and the Spanish Government defaults on all bond holdings over €2,500,000. The investor receives €2,500,000 from the Spanish Government and €7,500,000 from the seller of the CDS (the bank). The CDS payout ratio is computed below:
What are Credit Default Swaps?
Credit default swaps are credit derivatives that are used to hedge against the risk of default. They can be viewed as an income-generating pseudo-insurance. A CDS is an exchange of a fixed (or variable) coupon against the payment of a loss caused by the default of a specific security.
Consider the following example: An investor holds a large amount of Greek government bonds. However, due to Greece’s economic situation, the investor is worried about his exposure and the risk of the Greek government defaulting. The investor, therefore, enters into a default swap agreement with a bank. The investor will pay the bank a fixed (or variable – based on the exact agreement) coupon payment as long as the Greek government is solvent.
In the event of the Greek government defaulting, the bank will pay the investor the loss amount. A credit default swap is basically a fixed income (or variable income) instrument that allows two agents, who have opposing views about some other traded security, to trade with each other without having to own that security.
A bank loaned out $80,000,000 at 10% for 15 years to a large construction company that would use the money to build high-end condominiums. As the bank is required by law to insure all loans greater than $10,000,000, it purchases a credit default swap at 2% of the insured principal amount. Therefore, the bank pays the CDS seller 4% of the insured principal amount (4% of $80,000,000) every year for the next 15 years.
In return, the CDS seller will cover the unpaid amount in case the construction company defaults. If the construction company defaults (there is a recession and no one can afford high-end condominiums) and can only return $30,000,000 of the initial principal, the bank can claim the rest from the CDS seller. The payout ratio of the CDS is $50,000,000/$80,000,000 = 62.5%. Credit default swaps are usually used to insure the principal amount, and in this case, the bank still faces the possibility of losing out on the interest payments.