Give an Overview of the Credit Default Swap Market in Emerging Markets, Including Pricing Issues?

1.0 Introduction.

In the time span of merely 5 years back, since the credit default swap first introduced, the market for it has become overwhelmingly well established and trading of them has been increasing sharply. Besides, to show how important is the credit default swap in the market, the government had made a step to use them an indicator of credit risk of government and corporate bonds. (Özeren N.A, 2009)

2.0 Definition of Credit Default Swap.

A credit default swap (CDS) can be considered as an insurance. In a range of products available in credit derivatives market, CDS is one of the most liquid products. Transaction occurs when there are one party that seeks for a credit protection agrees to pay an amount of fee to the protection seller in exchange for a contingent payment if the credit event occurs during the term of the contract (refer Figure 1).The typical credit events that is defined by ISDA (International Swaps and Derivatives Association) are bankruptcy, insolvency, a credit downgrade, or failure to make a scheduled payment. (Chan-Lau J.A, Yoon, S.K 2004)

In the emerging markets, a significant number of contracts are traded more frequently in the credit derivatives markets reference sovereign issuers. Therefore, trading in single name sovereigns is more liquid than in corporate names. Since the CDS traded in emerging markets is referenced to sovereign issuers instead of corporate issuers, it shows the scarcity of corporate debt issued in terms of foreign currencies and the liquidity of emerging corporate debt issued. (Chan-Lau J.A, Yoon, S.K 2004)

3.0 Who is the Player?

‘Big' players in the market for CDSs in developing countries are hedge funds, emerging market mutual funds, pension funds, and banks. Hedge funds use CDSs to arbitrage the spread differential between the CDS and the referenced bond. Pension funds and emerging market dedicated mutual funds use CDSs to manage their exposure to emerging market sovereign bonds. Similarly, banks use CDSs to manage their balance sheet exposure to emerging market borrowers. (Chan-Lau J.A, Yoon, S.K 2004)

4.0 The uses of CDS

Speculation

Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as the CDX indices contain North American and Emerging Market companies. An investor might believe that they can make a profit from the differences between an entity's CDS spreads and the entity's bond yields. Hence, investor might speculate on an entity's credit quality, since generally CDS spreads will increase as credit-worthiness declines and vice versa. The investor might therefore buy CDS protection on a company to speculate that it is about to default.

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