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"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 entire article 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).
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