Credit Default Swaps

Section: Credit Default Swaps Estimated study time: 60 minutes Content: A credit default swap (CDS) is a bilateral contract in which the protection buyer pays periodic premiums (the CDS spread) to the protection seller in exchange for a payment contingent on a credit event affecting a reference entity or reference obligation. The protection buyer is economically short credit risk — it profits if the reference entity's credit quality deteriorates or defaults. The protection seller is economically long credit risk — it profits if no credit event occurs and the premiums are collected in full. CDS fundamentally allow separation of credit risk from interest rate risk, enabling targeted credit risk management without buying or selling the underlying bonds. The mechanics of a CDS contract include: the reference entity (the company or sovereign whose credit risk is being transferred), the reference obligation (the specific bond defining the seniority and recovery rate applicable to the swap), the notional principal (the face value amount of protection), the CDS spread (premium paid by the protection buyer, quoted in basis points per annum), and the credit events (the triggers for protection payment, typically including bankruptcy, failure to pay, and, for sovereign CDS, restructuring/repudiation). Upon a credit event, settlement can be physical (the protection buyer delivers the defaulted bond and receives par) or cash settlement (based on an auction-determined recovery price; the protection seller pays 100 minus the recovery price times notional). Cash settlement is now standard in the CDS market. CDS pricing is determined by the credit risk of the reference entity. The CDS spread ≈ PD * LGD (for flat hazard rate, continuous time), mirroring the bond credit spread derivation. In arbitrage terms: Bond…