CHAPTER 17OTC Derivatives and Collateral – Transaction Types – Credit Default Swaps

17.1 DEFINITION

A credit default swap (CDS) is an OTC derivative contract in which one party pays a periodic premium to its counterparty, in return for compensation for failure of a third party cash borrower to repay cash owed.

CDS are part of a family of financial products known as credit derivatives.

17.2 PURPOSE

Imagine that in April 2015 Firm A (a mutual fund) purchases a quantity of USD 10,000,000 Issuer X bonds maturing in October 2025, in the secondary market. The mutual fund’s intention is to hold the bond until maturity date. In October 2015, the mutual fund becomes concerned as to the creditworthiness of Issuer X, which brings into question whether Issuer X will be able to comply with its contractual obligations relating to the bond; those obligations are 1) to repay capital invested (USD 10,000,000.00) on the bond’s maturity date, and 2) to pay interest on the borrowing of cash via coupon payments when scheduled to occur.

Rather than selling the bond, the mutual fund considers that continuing to hold the bond is preferable, despite the risk of the issuer defaulting on its contractual obligations. However, in order to mitigate its risk, the mutual fund chooses to take out a form of insurance known as a credit default swap.

The mutual ...

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