Example of a CDS

Continuing on CDS, let us try to explore more about them for they are basic building blocks of most credit derivative transaction. Like in case of financial derivatives where most exotic structures can be broken into simple contracts of forwards and options, similarly in credit derivatives most structures are combinations of simple contracts like CDS.

The simplest – and most common – type of credit default swap is one where there is just one reference entity. This is called a single-name credit default swap. The reference entity can be any borrower, but is most often one of a few hundred widely traded companies (corporates or financials) or a handful of governments (sovereigns).

Let us try to think of a hypothetical CDS. An investor who wants to take a view on Reliance Industries might sell credit default swap protection. In May 2007, dealers quoted five-year credit default swap spreads on RIL at 47/53 basis points. This means the dealer quotes 47bp for a trade where the investor sells five-year protection and the dealer buys protection, and 53bp for a trade where the investor buys protection. (The difference between the two quotes is known as the ‘bid-offer spread’.)

On a typical trade size of Rs.10 crore, the protection seller would receive 470,000 a year, usually in four quarterly payments. Alternatively, the investor could buy protection for 53bp, paying Rs. 530,000 a year. If RIL defaults during the life of the trade and, following the default, say the value of the company’s debt falls to 30% of face value (the ‘recovery rate’), the protection seller will compensate the protection buyer for the Rs.7 crore loss.

Credit default swap (CDS)

Credit default swap (CDS)

Technical Definition : An over-the-counter contract to transfer the credit risk of a reference entity, in which the protection buyer pays a premium and the protection seller makes a payment in the event of a default (credit event) by the reference entity.

Non_technical explanation: The most common and simple of credit derivatives. It is not a swap in the conventional sense, but is more like an 'conditional' option. Much like an insurance contract, where on happening of a loss, the holder of the contract can ask to be reimbursed for the loss upto the contract amount. Similarly in CDS, the loss is a credit loss trigerred by a defined list of "credit events" (something like we have in accident policies in non-life insurance).

So in CDS, one party agrees to compensate the credit loss of the other in consderation of a premium upfront. The rationale for the existence and popularity of such contrcts - the party bearing the risk gets a premium (think of him as LIC), and the person buying the protection can manage the credit risk and get out of ("sell") credit positions which are not liquid. There can be other reasons as well, but more of that sometime later.