Credit Default Swap is widely blamed for economic crisis this time. So what is CDS: A credit default swap is a credit derivative contract in which one party -- protection buyer – pays a periodic fee to another party – protection seller – in return for compensation for default or similar credit event by a reference entity over a designated period of time. The reference entity is not a party to the credit default swap.
It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation as far as a credit event occurs. By paying a fee, the protection buyer is protected when the reference entity defaults, by transfer the credit risk to the protection seller. The protection Buyer’s asset remains subject to non-credit related elements of market risk. However, the protection buyer is not totally hedged all its credit risk, it still have the risk of simultaneous default by both the protection seller and the reference credit. The protection seller takes on the default risk of the reference entity in exchange for a negotiated fixed fee.
Even CDS is a relatively new form of derivative product, which emerged in the 1990s; the outstanding notional value of this marketplace has grown to around 26 trillion by 2006 according to ISDA.
A CDS is like an insurance policy, however it is not a policy since the protector buyer does not need to actually hold any asset or suffer any loss to require a settlement. CDS can provide better capital relief than an insurance policy. Because CDS strips out credit only, it can be less expensive than alternative risk transfer solutions while providing a faster payout. For a credit insurance policy, there can be a waiting period of between 180 and 360 days that much expire before the buyer can file a claim against the insurer to recover. With a CDS, the buyer can get payout in approximately four to six weeks following the event of a default.
A CDS contract allows the protection buyer to deliver the defaulted bond at par or to receive the difference of par and the bond’s recovery value. Therefore, a CDS is like a put option written on a corporate bond. The difference is that for a put option, the premium is paid when the deal is made, while for a CDS, the spread is paid during the life of the contract.
Example
Two parties enter a 5 year CDS on 01 March 2004.
• Notional principal = ￡100 million
• Buyer agrees to pay 90 basis points annually for protection against default. 100 basis points = 1%
• Case I: No Default
The buyer receives no payoff and pays ￡900,000 annually in 2005, 2006, 2007, 2008 and 2009
• Case II: Default event (seller notified on 01 June, 2007)
If the contract requires physical settlement then the buyer can deliver the bonds and receive face value of ￡100 million
If the contract requires cash settlement, an independent calculation agent will determine the mid market value of the cheapest-to-deliver bond. e.g. ￡35 per ￡100 face value. Then the payoff is ￡65 million
• Periodic payments cease (with an additional final accrual payment for 01 March 2007 to 01 June 2007)
For more details, please refer to my last year's article: