By far, the most popular type of credit derivative is the credit default swap. It is categorized as one of two credit default products. Not only is this form of credit derivative the most commonly used stand-alone product, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations, which will be discuss later. A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Because of the popularity of credit default swaps, the other type of credit default product —the credit default option—is rarely used. Hence, we will not discuss that product here.

Credit default swaps are used to shift credit exposure to a credit protection seller. Their primary purpose is to hedge the credit exposure to a particular asset or issuer. In this sense, credit default swaps operate much like a standby letter of credit or insurance policy. In contrast, a total return swap allows an investor to increase exposure to a reference obligation.

FundsA credit default swap in which there is one reference obligation is called a single- name credit default swap. When the reference obligation is a basket or portfolio of obligations (e.g., 10 high-yield corporate bond of 10 different issuers), it is referred to as a basket credit default swap.

In a credit default swap, the protection buyer pays a fee to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit event by the reference obligation or the reference entity. Should a credit event occur, the protection seller must make a payment.

The interdealer market has evolved to where single-name credit default swaps for corporate and sovereign reference entities are standardized. While trades between dealers have been standardized, there are occasional trades in the interdealer market where there is a customized agreement. For portfolio managers seeking credit protection, dealers are willing to create customized products. The tenor, or length of time of a credit default swap, is typically five years. Portfolio managers can have a dealer create a tenor equal to the maturity of the reference obligation or have it constructed for a shorter time period to match the manager’s investment horizon.

Credit default swaps can be settled in cash or physically. Physical delivery means that if a credit event as defined by the documentation occurs, the reference obligation is delivered by the protection buyer to the protection seller in exchange for a cash payment. Because physical delivery does not rely upon obtaining market prices for the reference obligation in determining the amount of the payment in a single-name credit default swap, this method of delivery is more efficient.

The payment by the credit protection seller if a credit event occurs may be a predetermined fixed amount or it may be determined by the decline in value of the reference obligation. The standard single-name credit default swap when the reference entity is a corporate bond or a sovereign bond is fixed based on a notional amount. When the cash payment is based on the amount of asset value deterioration, this amount is typically determined by a poll of several dealers. If no credit event has occurred by the maturity of the swap, both sides terminate the swap agreement and no further obligations are incurred.

The methods used to determine the amount of the payment obligated of the protection seller under the swap agreement can vary greatly. For instance, a credit default swap can specify at the contract date the exact amount of payment that will be made by the protection seller should a credit event occur. Conversely, the credit default swap can be structured so that the amount of the swap payment by the seller is determined after the credit event. Under these circumstances, the amount payable by the protection seller is determined based upon the observed prices of similar debt obligations of the reference entity in the market. Finally, the swap can be documented much like a credit put option (discussed later) where the amount to be paid by the protection seller is an established strike price less the current market value of the reference obligation.

In a typical credit default swap, the protection buyer pays for the protection premium over several settlement dates rather than upfront. A standard credit default swap specifies quarterly payments.

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Credit Default Swaps