A Better Way to Understand Credit Default Swaps Used to Speculate

Abstract:     
This article offers a new analysis of the financial characteristics of and the current marketplace for credit default swaps (CDSs) to determine where CDSs fit within the current tax regime and whether this result is sensible. The article begins by redefining CDSs by removing the framing of CDS parties as ''protection'' buyers and sellers. The article proceeds to discuss how CDSs contrast with insurance, guarantees, and notional principal contracts, and then how CDSs compare with options. Although options are often framed by reference to the ''rights'' of the holder, the article removes this frame and finds that the option holder's rights, like the terms of many other types of derivatives, simply demarcate the risk borne by the parties. After concluding that CDSs are best characterized as options, the article explains why open transaction treatment is suitable for CDSs and why current deductions for premiums paid are unwarranted.

This article also defines a new term - annuity-paid deep out-of-the-money derivative contracts (APDOs) - to describe a class of derivatives, a class that includes CDSs, for which the parties exchange one contingent payment for an annuity-like stream of payments. By defining this class of derivatives, the article identifies a derivative structure with a worldwide reach of even greater than the $58 trillion of notional amount of CDSs currently outstanding. Although CDSs are just one type of APDO, the analysis of the economics of CDSs also applies to APDOs referencing risk factors other than credit.

Keywords: Credit default swaps, deep out-of-the-money, options, annuity, annuities, guarantees, insurance, swaps, notional principal contracts, derivatives, credit, accrual, mark-to-market, open transactions

JEL Classifications: K34, G00

Accepted Paper Series