Credit Default Swaps: Some Basics

A credit default swap (CDS) is a contract associated with a company where the credit buyer pays the seller a fixed rate for the duration of the contract.  In return, the seller pays the buyer if certain credit events happen and the contract is closed.  Within it is listed a number of trigger events that will result in a payout to the buyer.  The payout is delivered usually in the form of the company bond at par (i.e. full price).  It is similar to any insurance product.  The other type of settlement is cash.  This is used for swaps on indices or structured finance tranches.

CDS contracts contain the reference entity's bond, the notional amount (i.e. the amount being insured), CDS spread (i.e. annual payment in basis points) and time of maturity.  The maturity is usually on March 20, June 20, September 20 and December 20.  Some contracts are based on more than one company.  These are called basket CDSs  If the contract is based on more than ten companies, it can be called a portfolio product.

The trigger events are bankruptcy, missed payment, re-structuring, obligation acceleration, obligation default and repudiation/moratorium.  Bankruptcy and missed payment are a company's failure to pay its debt.  Re-structuring debt is any change that adversely affects the buyer.  Obligation acceleration is when a loan is re-paid early and obligation default is when the borrower violates any condition in the agreement.  Repudiation/moratorium is a refusal to pay debt.  Bankruptcy, missed payment, obligation acceleration and repudiation/moratorium are defined as hard events and trigger the entire bond to be immediately due and payable.  Soft events, such as re-structuring, are changes in the agreement between the reference entities.  Some of them are reduction of interest/principal, postpone payment of interest or principal and a change of currency or contractual subordination.

CDSs provide a way to separate risks in complex securities such as convertibles.  They allow investors to hedge credit risk by shorting credit.  Investors can customize their risk profile by buying contracts on bonds of different companies and maturity dates, buying contracts on baskets and buying contracts to bet on the price direction of the reference entity.  CDSs may link different markets and provide liquidity in the credits markets.  Transactions are confidential.