The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• Credit derivatives enable the isolation and transfer of credit risk between two parties.

• By far, the most popular type of credit derivative is the credit default swap. There are single-name credit default swaps and credit default swap indexes.

• A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. A CDS is used to shift credit exposure to a credit protection seller. The payments are based on the notional amount of the contract.

• The CDS documentation will identify the reference entity (i.e., the issuer of the debt instrument) or the reference obligation. In addition, the documentation will specify what credit events are covered.

• In a CDS, the protection buyer pays a fee, the swap premium, to the protection seller in return for the right to receive a payment conditional upon the occurrence of a credit event. The CDS can call for cash settlement or physical settlement should a credit event occur.

• If reference obligations have different market values, the protection buyer has a cheapest-to-deliver option, which is the option to deliver the least expensive reference obligation to the protection seller in exchange for par.

• Unlike a single-name CDS, the underlying for a credit default swap index is a standardized basket of reference entities. The three most common are CDS for high-grade corporate bonds, high-yield corporate bonds, and loans.

• CDX indexes are used by market participants as a barometer ...