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Revision as of 21:48, 15 April 2005 by Ramin Nakisa (talk | contribs) (→Example)(diff) ← Previous revision | Latest revision (diff) | Newer revision → (diff)The Credit default swap (CDS) is the most widely used credit derivative. It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default (finance)) happening in the reference entity. A CDS is often used like an insurance policy, or hedge for the holder of a corporate bond. The typical term of a CDS contract is five years, although being an over the counter derivative almost any maturity is possible.
Definitions in a CDS Contract
A CDS contract typically includes a reference entity, which is the company who has issued some debt in the form of a reference obligation, usually a corporate bond. The period over which default protection extends is defined by the contract effective date and termination date. The contract nominates a calculation agent whose role is to determine when a credit event has occurred and also the amount of the payment that will be made in such an event. Another clause in a CDS contract is the restructuring, which determines what restructuring of the reference entity's debt will trigger a credit event. For example a company that is experiencing financial trouble may decide to extend the maturity of its bonds and therefore defer its payments. Depending on the restructuring specified in a CDS this may or may not trigger a credit event. Generally a contract that is more lax in its criteria for default is more risky and therefore more expensive. Another factor that affects the quote on a CDS contract is the debt seniority of the reference obligation. In the event of a company becoming bankrupt bonds that are issued as senior debt are more likely to be paid back than bonds issued as subordinated, or junior debt, hence junior debt trades at a greater credit spread than senior debt.
Sellers of CDS contracts will give a par quote for a given reference entity, seniority, maturity and restructuring e.g. a seller of CDS contracts may quote the premium on a 5 year CDS contract on Ford Motor Company senior debt with modified restructuring as 100 basis points. The par premium is calculated so that the contract has zero present value on the effective date. This is because the expected value of protection payments are exactly equal and opposite to the expected value of the protection payments. The most important factor affecting the cost of protection provided by a CDS is the credit rating of the reference obligation. Lower credit ratings imply a greater risk that the reference entity will default on its payments and therefore the cost of protection will be higher.
Example
A pension fund owns 10 million euros worth of a 5 year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt they buy a CDS from Derivative Bank on a nominal of 10 million euros which trades at 200 basis points. In return for credit protection the pension fund pays 2% of 10 million (200,000 euros) as quarterly payments of 50,000 euros to Derivative Bank. If Risky corporation does not default on its bond payments the pension fund makes quarterly payments to Derivative Bank for five years and receives its 10 million loan back after 5 years. If Risky Corporation defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the pension fund is refunded for its loss of 10 million euros.
Levels and flows
The Bank for International Settlements reported the notional amount on outstanding credit forwards and swaps to be $3.846 trillion in end-June 2004, up from $536 billion at the end of June 2001.
The Office of the Comptroller of the Currency reported the notional amount on outstanding credit derivatives from 667 reporting banks to be $1.909 trillion.