Mechanics of a Credit Default Swap

Let’s illustrate the mechanics of a standard single-name credit default swap. Assume that the reference entity is the ABC Corporation and the reference obligation is the ABC Subordinated Debenture due 2110. The swap premium—the payment made by the protection buyer to the protection seller —is 550 basis points. If a credit event occurs, the protection seller pays the protection buyer the notional amount of the contract. In our illustration, we will assume that the notional amount is $10 million.

The notional amount is not the par value of the reference obligation. For example, suppose that a bond issue is trading at 73.53 (par value being 100). If a portfolio manager owns $13.6 million par value of the bond issue and wants to protect the current market value of $10 million (approximately equal to 73.53% of $13.6 million), then the portfolio manager will want a $10 million notional amount. If a credit event occurs, the portfolio manager will deliver the $13.6 million par value of the bond and receive a cash payment of $10 million.

FundsThe standard contract for a single-name credit default swap calls for a quarterly payment of the swap premium. The quarterly payment is determined using one of the day count conventions in the bond market. The day count convention used for credit default swaps is actual/360, the same convention as used in the interest-rate swap market. A day convention of actual/360 means that to determine the payment in a quarter, the actual number of days in the quarter are used and 360 days are assumed for the year. Consequently, the swap premium payment for a quarter is

quarterly swap premium payment =

notional amount x annual rate (in decimal) x actual no. of days in quarter/360

For example, suppose the notional amount for a credit default swap is $10 million and there are 92 actual days in a quarter. Suppose also that the swap premium is 550 basis points (0.0550). Then the quarterly swap premium payment made by the protection buyer would be

$10,000, 000 x 0.0550 x 92/360 = $140,555.56

In the absence of a credit event, the protection buyer will make a quarterly swap premium payment. If a credit event occurs, the protection seller pays the protection buyer the notional amount, $10 million in our illustration, and receives from the protection buyer the ABC Subordinated Debenture due 2110 (i.e., the reference obligation).

Basket CreditDefault Swaps

With a basket credit default swap, when a payout must be made must be specified. For example, if a basket credit default swap has 10 reference obligations, does a credit event for just one of the 10 reference obligations result in the triggering of a payment by the protection seller? It depends. Basket default swaps can be structured in different ways.

The simplest case is that if any of the reference obligations default, there is a payout and then termination of the swap. This type of swap is referred to as a first-to-default basket swap. Similarly, if a payout is triggered only after two reference obligations default, the swap is referred to as a second-to-default basket swap. In general, if it takes k reference obligations to trigger a payout, the swap is referred to as a k-to-default basket swap.

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