Credit Default Swap - Description

Description

However, if the associated credit instrument suffered a credit event at t₅, then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller.

A CDS is linked to a "reference entity" or "reference obligor", usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the "spread" charged by the seller to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction.

A default is often referred to as a "credit event" and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower's credit rating. CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration. Most CDSs are in the $10–$20 million range with maturities between one and 10 years. Five years is the most typical maturity.

An investor or speculator may “buy protection” to hedge the risk of default on a bond or other debt instrument, regardless of whether such investor or speculator holds an interest in or bears any risk of loss relating to such bond or debt instrument. In this way, a CDS is similar to credit insurance, although CDS are not subject to regulations governing traditional insurance. Also, investors can buy and sell protection without owning debt of the reference entity. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, CDSs can also be used in capital structure arbitrage.

A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. The CDS may refer to a specified loan or bond obligation of a “reference entity”, usually a corporation or government.

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated.

If the investor actually owns Risky Corp's debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses).

If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur:

• the investor delivers a defaulted asset to Bank for payment of the par value, which is known as physical settlement;
• AAA-Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if Risky Corp defaults there is usually some recovery, i.e., not all the investor's money is lost), which is known as cash settlement.

The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000. Payments are usually made on a quarterly basis, in arrears. These payments continue until either the CDS contract expires or Risky Corp defaults.

All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs having to perform under these contracts.