"Introduction to Credit Derivatives - Credit Default Swaps"

by Janet Tavakoli

Summary:

Credit default swaps, CDSs, are the most common type of credit derivatives transaction. This very simplified article explains the importance of the counterparty protection provider in these transacitons.

Click here for "Introduction to Credit Derivatives" as a pdf file.

Definition of Credit Derivative Credit derivative is the generic term for any derivative contract used to transfer credit risk on a reference entity or reference obligor between a credit protection seller that is short the credit risk, and a credit protection buyer that is long the credit risk. Credit derivatives are distinct from financial guarantees and credit insurance. The credit protection buyer does not have to own the underlying security or actually suffer a loss. The credit protection seller has no recourse to the reference entity and does not have the right to sue the reference entity/obligor for recovery. Definition of Credit Default Swap A credit default swap is a bilateral contract between the protection buyer that is short the credit risk and the protection seller that is long the credit risk. Usually the protection buyer pays a periodic fee to the protection seller in exchange for the protection seller’s contingent payment if a pre-defined credit event affects the reference entity or reference obligor. A credit default swap (CDS) is a transaction in which the credit protection buyer pays a fee, usually called a premium, to a credit protection provider (the seller) in exchange for a payment if a credit default event of a reference asset(s) occurs. The buyer of a credit default swap is the credit protection buyer, the premium payer, and is short credit risk. Put another way, the protection buyer is the seller of default risk similar to the seller of a bond. The seller of the credit default swap is the credit protection seller (also called the protection provider), the receiver of the premium and is a buyer of credit risk. The protection seller is long credit risk similar to the buyer of a bond. The protection seller is often called the investor and makes no payment unless a credit default event occurs. The protection seller and the protection buyers are called credit default swap counterparties. Pay-as-you-go (PAUG) and upfront premium/floating rate structures have been used for several years in the credit default swap market, and terms vary. Tavakoli, J. Credit Derivatives & Synthetic Structures, John Wiley & Sons, 2nd Edition 2001 (1st Edition 1998).