CDS
A swap is a financial contract where two parties exchange (swap) cash flows based on different financial instruments, interest rates, or currencies — usually over a period of time.
In short:
“You pay me based on your rate or currency, I pay you based on mine.”
Swaps are over-the-counter (OTC) contracts — they’re privately negotiated, not traded on exchanges.
Common Types of Swaps
| Type | What Is Exchanged | Example Use |
|---|---|---|
| Interest Rate Swap (IRS) | Fixed interest payments ↔ floating rate payments | Company locks in predictable interest costs |
| Currency Swap | Payments in one currency ↔ payments in another | Company borrowing in foreign currency |
| Commodity Swap | Fixed commodity price ↔ floating market price | Airline or oil producer stabilizing cash flows |
| Credit Default Swap (CDS) | Credit risk protection ↔ periodic premium | Protect against a company defaulting |
| Equity Swap | Return on stock/index ↔ fixed or floating payments | Hedge or gain exposure without buying stock |
1. Interest Rate Swap (most common)
This is the classic and most widely used form of swap.
Purpose:
To hedge against changes in interest rates or convert debt exposure from variable to fixed (or vice versa).
Example:
- Company A has a floating-rate loan (pays LIBOR + 1%).
- Company B has a fixed-rate loan (pays 5%).
They decide to swap interest payments.
| Party | Pays | Receives |
|---|---|---|
| Company A | Fixed 5% | Floating (LIBOR + 1%) |
| Company B | Floating (LIBOR + 1%) | Fixed 5% |
After the swap:
- A effectively pays a fixed rate (hedging interest rate volatility).
- B effectively pays a floating rate (if it expects rates to drop).
Result: Each company aligns its debt exposure with its preference.
2. Currency Swap
Used when two parties in different countries want to borrow in each other’s currency.
Example:
- An Australian company needs USD.
- A U.S. company needs AUD.
They agree to swap:
- Principal amounts today (AUD ↔ USD)
- Periodic interest payments in each currency
- Repay the principals at the end
Benefit: Each company avoids foreign borrowing costs and currency exposure.
3. Commodity Swap
Used to stabilize the cost of raw materials or revenues from commodities.
Example:
- An airline wants to lock in jet fuel prices.
- A bank agrees to pay floating (market oil price) and receive fixed.
Result:
- The airline pays a fixed price regardless of oil volatility → cost certainty.
4. Credit Default Swap (CDS)
Essentially insurance against a bond default.
- Buyer pays regular premiums to the seller.
- If a borrower (like a company or government) defaults, the seller compensates the buyer.
This was the instrument Bill Ackman used in 2020 to hedge against corporate defaults — and in 2008, CDSs were central to the financial crisis.
5. Equity Swap
Used to exchange returns of an equity or index for a fixed or floating payment.
Example:
- Bank pays fund manager the S&P 500 return.
- In return, the fund manager pays the bank a fixed 3% interest.
The investor gains stock market exposure without owning the actual shares.
Why Companies Use Swaps
| Objective | Description |
|---|---|
| Hedging | Manage risk from interest rate, currency, or commodity price movements. |
| Speculation | Bet on movements in rates, spreads, or market prices. |
| Funding optimization | Access cheaper financing by borrowing where rates are lowest, then swapping back. |
| Balance sheet management | Match asset and liability structures (e.g., fixed vs. floating). |
Risks of Swaps
| Risk Type | Description |
|---|---|
| Counterparty risk | One party might default (since swaps are OTC). |
| Market risk | Rates or prices can move unfavorably. |
| Liquidity risk | Hard to exit before maturity. |
| Valuation complexity | Some swaps (e.g., CDS, exotic types) are hard to price. |
| Regulatory risk | Increasing oversight since the 2008 crisis. |
Real-World Examples
| Scenario | Swap Type | Purpose |
|---|---|---|
| Bank hedging variable-rate mortgage exposure | Interest Rate Swap | Reduce risk from rising rates |
| Airline fixing fuel cost | Commodity Swap | Lock in stable operating costs |
| Apple hedging USD/EUR earnings | Currency Swap | Reduce FX risk |
| Bill Ackman’s 2020 hedge | Credit Default Swap | Protect against corporate bond defaults |
Simplified Interest Rate Swap Example (Numerical)
- Notional: $10 million
- Fixed rate: 5%
- Floating rate: LIBOR + 1%
- Period: 1 year, semiannual payments
- If LIBOR = 3% for both periods:
Then floating = 4%.
Company A (fixed payer) pays 5%, receives 4% → net pays 1% of $10M = $100,000.
If LIBOR rises to 6%, floating = 7%.
Now A pays 5%, receives 7% → receives 2%, or $200,000 gain.
That’s how an interest rate swap protects against rate changes.
In Summary
| Concept | Description |
|---|---|
| Definition | Exchange of cash flows or returns between two parties |
| Main types | Interest rate, currency, commodity, credit, equity |
| Purpose | Hedge, speculate, or optimize funding |
| Traded | Over-the-counter (OTC), not on exchanges |
| Risk | Counterparty and market risk |
Bill Ackman’s big bet in 2020 is one of the most famous trades in modern financial history — it turned $27 million into about $2.6 billion in just over a month. Here’s how he did it
Background: What was happening in early 2020
In February–March 2020, as COVID-19 started spreading globally, markets were still near all-time highs.
Ackman, through his hedge fund Pershing Square Capital Management, believed the virus would cause:
- Massive economic shutdowns
- Corporate credit stress and defaults
- A sharp drop in equity markets
Rather than selling all his stock holdings (which would trigger taxes and send a bad signal), he looked for a hedge — a way to profit if credit markets crashed.
The Trade: Credit Default Swaps (CDS)
Ackman bought credit protection on major investment-grade and high-yield bond indexes — essentially insurance against a corporate credit crisis.
- Instruments: CDS Indexes (Credit Default Swaps on indices like CDX and iTraxx)
- Cost: About $27 million in premiums
- Purpose: If corporate bond spreads widened (i.e., market started to fear defaults), the value of his CDS would skyrocket.
What Happened Next
When COVID panic hit markets in March 2020, credit spreads exploded — meaning the cost of insuring corporate bonds surged.
Because Ackman owned that insurance, the value of his CDS positions soared.
- In less than a month, his hedge gained roughly 100×.
- Pershing Square’s position was sold for $2.6 billion profit by late March 2020.
At the same time, the overall stock market plunged nearly 35%.
What He Did With the Profit
Ackman immediately redeployed the $2.6 billion profit:
- He bought more shares of his favorite long-term holdings at bargain prices — like Hilton, Lowe’s, Restaurant Brands International, Chipotle, and others.
- This amplified Pershing Square’s recovery when markets rebounded.
By the end of 2020, Pershing Square’s fund was up ~70% for the year, one of the best hedge fund performances in the world.
Why It Worked
- Perfect timing — he acted before markets priced in COVID risk.
- Efficient hedge — a small bet with asymmetric payoff.
- Deep understanding of credit markets — he knew CDS would react faster than equities.
- Psychological edge — he stayed calm and redeployed capital at the market bottom.
Lessons from Ackman’s 2020 trade
| Principle | Explanation |
|---|---|
| Asymmetric risk/reward | Small cost, massive potential upside |
| Crisis hedging via credit markets | Credit often reacts earlier than stocks |
| Liquidity during crisis | Cash from hedge allowed him to buy cheap assets |
| Preparedness beats prediction | He didn’t predict the pandemic — he prepared for any shock |