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. Read the rest of this entry »
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. Read the rest of this entry »
A collateralized debt obligation (CDO) is backed by a diversified pool of one or more types of debt obligations (e.g., U.S. domestic investment-grade corporate bonds, high-yield corporate bonds, emerging market bonds, bank loans, asset-backed securities, and residential and commercial mortgage-backed securities). The funds to purchase the collateral assets are obtained from the issuance of bonds. There is a collateral manager responsible for managing the collateral of assets.
A CDO is classified as a cash CDO or a synthetic CDO. The adjective “cash” means that the collateral manager purchases cash market instruments. A synthetic CDO is so named because the collateral manager does not actually own the pool of assets on which it has the credit risk exposure. Stated differently, a synthetic CDO absorbs the credit risk, but not the legal ownership, of the reference obligations. A credit default swap allows institutions to transfer the credit risk, but not the legal ownership, of the reference obligations it may own. Read the rest of this entry »
