An equity default swap (EDS) is a form of OTC derivative. While technically an equity derivative, it behaves like a hybrid of a credit derivative and an equity derivative. The name “equity default swap” may seem peculiar—how can equity default? The answer is that the product is named by analogy with credit default swaps (CDSs), whose structures it mimics.
As with a credit default swap, an equity default swap is a vehicle for one party to provide another protection against some possible event relating to some reference asset. With a credit default swap, the reference asset is a debt instrument, and protection is provided against a possible default or other credit event. With an equity default swap, the reference asset is some company’s stock, and protection is provided against a dramatic decline in the price of that stock. For example, the equity default swap might provide protection against a 70% decline in the stock price from its value when the equity default swap was initiated. The event being protected against is called the trigger event or knock-in event.
Other than the difference in the type of event being protected against, a credit default swap and equity default swap are structured identically. There are two parties to the agreement. Maturities are for several years, with five years being typical. The party buying protection pays the other a fixed periodic coupon for the life of the agreement. The other party makes no payments unless the trigger event occurs. If it does occur, the equity default swap terminates, and the protection seller makes a specified payment to the protection buyer. This is calculated as
notional amount (1 – recovery rate)
where the notional amount is simply a dollar sum. In formula , recovery rate serves only to make the equity default swap more analogous to a credit default swap. Its role is similar to the recovery rate that would be realized on a defaulted debt obligation. However, the recovery rate for an equity default swap is fixed—typically at 50%.
An equity default swap is similar to a deep out-of-the-money, long-dated American digital put. A difference is that the option premium is paid in installments that cease when the option is triggered. It is more useful to think of the equity default swap as an extension of the credit default swap concept. When a credit default swap is triggered by a corporate default, that corporation’s stock price will typically have fallen to almost 0. Because equity default swap triggers are set for such steep stock price declines, trigger events will almost always be associated with some sort of deterioration in the corporation’s credit. For example, if an equity default swap is triggered by a 70% decline in the stock price, it provides protection against less severe corporate impairment than that which a credit default swap protects against. In this regard, the equity default swap truly behaves as a form of hybrid between a credit derivative and an equity derivative.
Equity default swap are quoted as spreads over Libor. Because an equity default swap is more likely to be triggered than a credit default swap, they generally trade at higher spreads than credit default swap.
Equity default swaps have a number of advantages over credit default swaps. Their trigger events are more easy to define—there is generally little ambiguity as to whether a given stock price has or has not fallen to a specified lever, but with credit default swaps, there can be corporate events that may or may not constitute default. Also, recovery rates are fixed for equity default swaps while they must somehow be determined for a credit default swap following an actual default. Finally, credit default swaps are limited in that they protect against only the most severe form of corporate impairment. Equity default swaps can be structured with various trigger levels loosely corresponding to various degrees of corporate impairment.
Equity default swaps are employed in ways similar to credit default swaps. They may be used to structure synthetic CDOs. Some CDOs use them exclusively. These are called equity collateralized obligations or ECOs.
As long-dated far out-of-the-money options, equity default swaps pose financial engineering challenges. One approach is to employ techniques of equity derivatives pricing. The other is to use techniques of credit derivatives pricing. Equity default swaps clearly present an opportunity to arbitrage between equity derivatives markets and credit derivatives markets, which should cause convergence in pricing.
Equity default swaps can be structured with multiple reference stocks. These structures may have a first to “default” or nth to “default” trigger.