Credit Default Swaps
Pamela Heijmans
Matthew Hays
Adoito Haroon
Credit Default Swaps – Definition
• A credit default swap (CDS) is a kind of
insurance against credit risk
– Privately negotiated bilateral contract
– Reference Obligation, Notional, Premium
(“Spread”), Maturity specified in contract
– Buyer of protection makes periodic payments to
seller of protection
– Generally, seller of protection pays compensation
to buyer if a “credit event” occurs and contract is
terminated.
Credit Default Swaps – Example
Protection
Buyer
Spread, b basis
points per annum
Payment on credit event
Protection
Seller
Total return less
credit loss on the
reference entity
Reference
Entity
Example:
Notional: $10 million dollars
Spread: 100 bps per annum
Quarterly payment frequency
Payment of $25,000 quarterly
Credit Default Swaps - Types
• Exist for both corporate reference entities and
Asset Backed Securities (ABS)
– Corporate CDS are relatively simple; first emerged
round about 1993; became widely used by late
90’s/early 2000’s, particularly after introduction of
ISDA template in July 1999
– ABS CDS are more complex; first appeared around
2003; grew substantially in 2005 after introduction of
ISDA “Pay as you go” template in June of that year
• Exist for a variety of types of ABS; most common for
Residential Mortgage Backed Securities (RMBS); but, size of
markets for CDS on CDOs and CDS on CMBS also substantial.
Credit Default Swaps – Credit Events
• For corporates, quite straightforward
– Credit event results in payment from protection seller to
buyer and termination of contract
– Most common types of credit events are the following
• Bankruptcy
– Reference entity’s insolvency or inability to repay its debt
• Failure to Pay
– Occurs when reference entity, after a certain grace period, fails to make
payment of principal or interest
• Restructuring
– Refers to a change in the terms of debt...