10.2 Credit Default Swaps

The credit derivatives market has grown quickly in recent years, fuelled by the need to transfer credit risk efficiently and develop ever-more sophisticated products for investors. A credit derivative is an agreement designed to shift credit risk between parties and its value is derived from the credit performance of a corporation, sovereign entity or security. Credit derivatives can be traded on a single-name basis (referencing a single component such as a corporate) or a portfolio basis (referencing many components such as 125 corporate names).

Credit derivatives instruments are important since they represent opportunities for trading, hedging and diversification of counterparty risk. However, credit derivatives as a product class give rise to a significant amount of counterparty risk. Indeed, the continued development of the credit derivative market is contingent on control of this counterparty risk. This is a key role of CCPs, as discussed in Chapter 7.

10.2.1 Basics of CDSs

Many credit derivatives take the form of a CDS, which transfers the default risk of one or more corporations or sovereign entities from one party to another. In a single-name CDS, the protection buyer pays an upfront and/or periodic fee (the premium) to the protection seller for a certain notional amount of debt for a specified reference entity. If the reference entity specified undergoes a credit event then the protection seller must compensate the protection buyer for the associated ...

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