Credit Default Swap

Also known as Default Swaps, Credit Swaps, Single Name Credit Default Swap
This allows you to buy (or sell) protection on an investment linked to a single named entity.
Spreads are generally between 10 and 30 basis points for a single name CDS contract.
Similar to insurance although unlike insurance you do not need to own the asset so it can be purely speculative


A credit default swap is an agreement in which one party buys protection against losses occurring due to a credit event of a reference entity up to the maturity date of the swap.

  • The protection buyer pays a periodic fee for this protection up to the maturity date unless a credit event triggers the contingent payment.

  • If a credit event occurs, the buyer of the protection only needs to pay the accrued fee up to the day of the credit event and deliver an obligation of the reference credit in exchange for the protection payout.




There are 2 categories
1) Single Name - these are the most popular
The simplest type of CDS is one where there is just one reference entity (called a single name CDS)
The reference entity can be any borrower but is typically one of a few hundred widely traded companies (corporate or financial) or a handful of governments (sovereign)


A single name CDS acts rather like an insurance contract against the default of that reference entity.



2) Multiname - also known as Collaterised Debt Obligations and is a portfolio of debt instruments


CDS payments are generally made in arrears every quarter
Protection is defined in basis points


The total amount paid every year (as a percentage of the notional) is known as the CDS spread
(eg 250 spread = 2.5% a year)


What is an Obligation ?

In a CDS, there are two types of obligations

  • Obligations that trigger a credit event (eg failure to pay on a bond or loan).

  • Delivery obligations are the assets that can delivered if a credit event has occurred.


There are different categories of obligation

  • Payment

  • Borrowed money

  • bond or loan



Settlement of a CDS contract

Physical settlement - most common - protection buyer receives par
Cash settlement - not that common - protection buyer receives (par recovery)




Example
Company A's five year CDS trades at a level of 0.65% paid semi-annually
A 5 year FRN trades at par with a margin of 6 months LIBOR + 0.55%
What is the basis ?


Default Swap Basis = Default Swap Spread - FRN Spread
= 65-55
= 10 basis points



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