Credit Derivatives: Trading, Investing and Risk Management, Second Edition

8

Credit Default Swaps; Product Description and Simple Applications

8.1 CDS PRODUCT DEFINITION

8.1.1 Contract Description and Example

A (single name) credit default swap (CDS) is a bilateral, off-balance-sheet agreement between two counterparties, in which one party (‘the writer’) offers the other party (‘the buyer’) protection against a credit event¹⁸ by a third party (‘the reference name’) for a specified period of time, in return for premium payment.

The reference entity in the transaction may be a corporate (including banking entity) or a sovereign. In the case of a sovereign reference entity the default risk typically refers to obligations issued in a currency other than that of the sovereign.

The ‘buyer’ and ‘writer’ are both referred to as ‘counterparties’. Note again that ‘buyer’ and ‘writer’ are defined here in terms of protection rather than risk. As some traders and investors use the same terms to refer to buying or selling risk (the opposite position), it is obviously important to be clear which terminology you and counterparties are using.

The ‘buyer’ and the ‘writer’ are often banks, insurance companies, or hedge funds, but can be any corporate or sovereign entity in principle. The quality of the counterparty to the deal has risk and pricing implications (but note the contents of section 8.1.2).

We can see, before looking at details of the contract, that the deal is a portfolio deal - it is dependent on three parties. We shall examine the pricing impactions ...