CREDIT DEFAULT SWAP

Term

CREDIT DEFAULT SWAP (CDS)

Meaning

A swap designed to transfer the credit exposure of fixed income products between parties.

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.

The Basics of Single-Name Credit Default Swaps

To understand the credit event auction default process, it is helpful to have a general understanding of single-name credit default swaps. A single-name CDS is a derivative in which the underlying instrument is a reference obligation, or a bond of a particular issuer or reference entity. Credit default swaps have two sides to the trade: a buyer of protection and a seller of protection. The buyer of protection is insuring against the loss of principal in case of default by the bond issuer. Therefore, credit default swaps are structured so that if the reference entity experiences a credit event, the buyer of protection receives payment from the seller of protection.

Credit Event

In the CDS world, a credit event is a trigger that causes the buyer of protection to terminate and settle the contract. Credit events are agreed upon at the time the trade is entered into and are part of the contract. The majority of single-name CDSs are traded with the following credit events as triggers: reference entity bankruptcy, failure to pay, obligation acceleration, repudiation and moratorium.