Credit Derivatives Copyright 2004
This session covers the main uses of credit default swaps, the key product in the creditderivative market. In particular, we look at the applications of credit default swaps incustomised structured products : credit linked notes, repackaged notes, and syntheticcollateralised debt obligations.In the appendix we have briefly covered other types of credit derivative : total returnswaps and credit spread options.We start with an introduction to the basic credit default swap product and its uses.Credit derivatives are bilateral contracts tied to the performance of an underlyingreference credit(s) or loan(s). They allow users to manage their credit exposure via theisolation and transfer of credit risk.The figure below shows the structure of a credit default swap. It is a contract wherebyone party (the protection seller) agrees to receive periodic payments (the CDS spreador fee) in return for making a contingent payment to the protection buyer, following adefault on a specific security or loan.
Credit Default Swap Structure
ProtectionBuyer ProtectionSeller ReferenceEntity/Security(Bond/Loan)
Contingent PaymentPeriodicFee (bps), s.a. A/360
The credit risk faced by the protection buyer as a result of holding the reference securityhas been stripped off, and effectively trades separately.So, what are the motives of the counterparties ?Perhaps the protection seller is a bank that wants credit exposure to a particular sector to which it does not have a have particularly strong presence. Alternatively, it could bean investor seeking access to a particular credit that is not normally available in themarket.The protection buyer may simply want to hedge the credit risk on the bond for a periodof time.
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