Derivatives: A Pocket Guide To

4
A POCKET GUIDE TO:
Derivatives
I n s i d e - O u t E d u c a t io n a l P r o g r a m m e
FOR PROFESSIONAL INVESTORS USE ONLY – NOT FOR DISTRIBUTION TO THE GENERAL PUBLIC
? What are derivatives?
? Why are they used in investment portfolios?
? What is the difference between swaps, options, futures

and forwards?
? How are different types of contracts commonly used

by investors?
 Derivatives play an increasingly important role in

investment portfolios, both to hedge risks and target
higher returns. However, some investors may be wary
of these instruments due to their perceived complexity
and risks. This guide aims to answer key questions
about derivatives and demonstrate their common use
in modern portfolios.
Contents
What are derivatives? 1
Contractual agreements between counterparties 2
History 3
The structure and use of derivatives contracts 4
Interest rate swap 7
Total return swap 9
Credit default swap 11
Currency option 12
Interest rate and government bond futures 15
Currency forward 17
Which derivative is right for your investment strategy? 19
Why Goldman Sachs Asset Management? 21
Multi-layered approach to risk management 22
Glossary 23
Learn more 29
1 A pocket guide to Derivatives
What are derivatives?

Derivatives are extremely flexible financial instruments that are
widely used in portfolios today. Their value is derived from an
underlying asset.
They can provide a number of potential benefits to investors,
namely greater flexibility in structuring portfolios, and are
primarily used as a tool to transfer risk (hedging unwanted risk,
insurance) or as an instrument to capture market mispricings
(arbitrage, speculation).
Among the most common – and the most liquid – examples

of derivatives are interest rate swaps, total return swaps,
credit default swaps, currency options, interest rate and
government bond futures and currency forwards. This guide
explains the differences between each of these instruments
and explores how they work.
A pocket guide to Derivatives 2
Contractual agreements
between counterparties
Participants in derivatives markets make this possible by
entering into a contractual agreement to exchange cash or
securities at a future date, the value of which is determined
by, but not limited to, the performance of the underlying asset
during the life of the contract. Derivatives can be traded on an
exchange or negotiated privately and traded directly between
two counterparties (“over the counter”).
Although the world of derivatives encompasses a wide variety
of financial instruments, the most common contracts fall into
four categories:
• Swaps: Counterparties agree to exchange a series of
cash flows at a future date
• Options: Counterparties have the right, but not the obligation,
to buy (or sell) an asset at a future date
• Futures: Counterparties are bound by a standardised obligation
to buy (or sell) an asset at a future date
• Forwards: Counterparties are bound by a non-standardised
obligation to buy (or sell) an asset at a future date
History
The derivatives market has a history of solid, consistent growth
(see chart). Measured by notional amounts outstanding, total
interest rate swaps, options and currency swap contracts
accounted for more than $400 trillion at the end of 2008,
according to the International Swaps and Derivatives Association
(ISDA). There is hardly a financial security or instrument that does
not have a corresponding derivative contract associated with it.
Derivatives are a huge and growing market

In trillions of $403.1 trillion
US dollars (to 30 June 2008)
450
400
350
300
250
200
150
100
50
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
Source: International Swaps and Derivatives Association. Total interest rate swaps, options and currency swaps
– notional amounts outstanding at year-end, all surveyed contracts.
Derivatives have evolved into a wide range of financial

instruments. The following pages provide examples of each main
category – swaps, options, futures and forwards – and explore
their benefits.
The structure and
use of derivatives
contracts
Derivatives contracts generally involve a pair of
counterparties who agree to exchange cash or
securities at a future date. Although this overall
premise applies across all types of derivatives,
each instrument has its own idiosyncracies in
terms of application and execution.
Why and how are derivatives used?

Derivatives provide greater flexibility in structuring
investment portfolios. The benefits of using
derivatives include:
 Cost efficiency: transact for minimal cost
 Flexibility: implement investment ideas

across many markets
 Independence: avoid compromises

or clashes between investment ideas
 Precision: avoid involuntary risks
 Diversification: gain access to new

investment opportunities
There is a wide variety of derivatives available to investors,

each offering its own potential benefits and potential drawbacks.
This section illustrates step-by-step how interest rate swaps,
total return swaps, credit default swaps, currency options,
interest rate and government bond futures and currency
forwards contracts are usually structured, implemented and
settled. It also sets out some of the common uses, pros, cons
and risks of these derivatives contracts and gives details on basic
legal requirements and typical pricing criteria.
General risks of derivative instruments
An investment in derivatives may involve additional

risks for investors. These additional risks may arise as
a result of any or all of the following:
(i) Leverage factors associated with transactions in

the portfolio; and/or
(ii) The creditworthiness of the counterparties to such

derivative transactions; and/or
(iii) The potential illiquidity of specific derivative

instruments in unforeseen market environments.
Interest rate swap

Counterparties agree to exchange cash flows on periodic
settlement dates over a certain period of time.
Floating rate 1
A B
Fixed rate 2
1 Counterparty A and counterparty B agree on a notional

principal amount and set the term period of the contract.
2 A agrees to pay B a floating rate, typically LIBOR, on the

notional principal amount.
3 B agrees to pay A a fixed rate on the notional principal amount.
4 At each settlement date, the floating and fixed payments

are netted so that only one payment is made by one party
to the other.
For illustrative purposes only.

1 The London Interbank Offered Rate (LIBOR) is traditionally used as the floating rate in interest rate swaps.
2 Pre-determined fixed interest rate negotiated at the beginning of the swap contract.
Source: Goldman Sachs Asset Management.
Market traded Over the counter.

Common uses • Hedge interest rate exposure
• Relative value country trades
• Yield curve trades
• Swap spread trades
Pros • High liquidity

• Minimal cash outlay
• Highly customisable
• Expands investment opportunity set
Cons • Not traded in organised secondary

market
• Limited availability to small investors
Risks • Operational
Refer to page 7 for general risks of
derivative instruments.
Collateral Depends on the credit quality of the

requirements swap’s counterparties and the contract’s
terms (generally 1% to 2% of notional).
Collateral is marked to market.
Pricing Based on the expected value of future

cash flows to be exchanged.
Basic legal • ISDA Master Agreement and schedule

requirements • Credit Support Annex
• Interest rate swap confirmation
Total return swap

Counterparties agree to exchange cash flows based on the
performance of a benchmark asset or index.
Floating rate + Premium 1
A B
Benchmark Rate of Return 2

2 A agrees to pay B a floating rate, typically LIBOR, on the

notional principal amount plus sometimes a premium.
3 B agrees to pay A the total rate of return of the agreed

benchmark during the life of the contract.
4 At settlement date, payments are netted so that only one

payment is made by one party to the other.

1 The London Interbank Offered Rate (LIBOR) is traditionally used as the floating rate in total return swaps.
The premium over LIBOR is usually based on, among other things, the liquidity, volatility and credit quality of
the underlying assets that comprise the index.
2 Total rate of return of an index (e.g. Barclays Aggregate Bond Index, S&P 500) selected at the beginning of
the swap contract.

Common uses • Hedge beta risk
• Synthetic exposure to index or asset class
• Synthetic exposure to otherwise inaccessible
market (e.g., emerging markets)
Pros • Minimal cash outlay
Cons • Not traded in organised secondary market
• Some exotic markets or benchmarks may
have limited liquidity
Collateral Depends on the characteristics of the
requirements underlying benchmark (generally 1% to 2%
of notional). Collateral is marked to market.
Pricing Based on the difference between the
performance of the benchmark and the
floating rate.
• Total return swap confirmation
Credit default swap

Counterparties agree for buyer to pay periodic fee in exchange
for recovery payment from seller as an insurance mechanism in
case of credit event. A form of protection against credit risk.
Premium 1
Buyer Seller
If credit event 2 :
full notional amount
If credit event 2 :
physical bonds
1 Protection Buyer and protection Seller agree on a notional

2 Buyer agrees to pay Seller a premium based on the

notional amount in exchange for protection from a credit
event (similar to an insurance policy).
3 If credit event occurs, Seller pays Buyer the full notional

amount while Buyer transfers to Seller the physical bonds
underlying the contract.
4 If no credit event occurs during the life of the contract,

Seller keeps the premiums paid by Buyer.

Credit default swap contracts can also be settled in cash. In this case, if a credit event occurs, the seller
agrees to pay the buyer the full notional amount of the contract minus a “final price”, which is determined by a
valuation mechanism that takes into consideration the odds of recovery on the defaulted/downgraded security
underlying the contract.
1 The protection buyer agrees to pay a premium that is based on the notional amount of the transaction and
the credit quality of the underlying security.
2 A credit event can include company restructuring, insolvency or default.
Common uses • Hedge credit risk

• Single-name exposure (long and short)
• Basis trades (e.g., CDS versus cash bonds)
• Widen credit spectrum exposure

Cons • Not traded in organised secondary market

• Default settlement can be lengthy
• Basis

requirements underlying asset (generally 1% to 2% of
notional). Collateral is marked to market.
Pricing The protection buyer agrees to pay a

premium on the notional amount of the
transaction based upon the probability of a
credit event on the underlying security.

• Credit default swap confirmation
Currency option
Counterparties agree on the right, but not the obligation, to buy
(or sell) currency at a specified exchange rate during a specified
period of time. A form of protection against adverse movements in
exchange rates.
Premium
Buyer Seller
Currency at specified
exchange rate
1 Buyer and Seller agree on the exchange rate and term

period of the contract.
2 Buyer agrees to pay Seller a premium based on the

number of contracts purchased.
3 Seller agrees to pay Buyer currency at the specified

exchange rate.
4 Contracts are settled each occasion Buyer purchases

currency from Seller until the expiration date.

Common uses • Hedge against movements in exchange

rates
• Hedge interest rate exposure
• Synthetic exposure to currency

Cons • Not traded in organised secondary

market

requirements underlying currency (generally 1% to 2% of
Pricing Based on the difference between the

current exchange rate and the specified
exchange rate, with a consideration of the
expected movement before the expiry
date.

• Currency option confirmation
Interest rate and government

bond futures
Contracts with an underlying asset linked to interbank borrowing
rates or government bonds. Payments are set by standard contract
sizes and the performance of the underlying instrument.
Futures Exchange
Broker 1 Broker 1
Buyer Seller
1 Buyer (long) and Seller (short) agree on size and term period,
and select futures contracts to match desired deal composition.
2 Futures Exchange takes initial margin from Buyer and Seller.
3 Contracts are re-settled daily, so Buyer and Seller must

be ready to pay the exchange (margin call) each time their
position generates losses.
4 Contracts are settled, in cash only, based on the contract’s

price on the expiration date2.
1 Buyers and sellers will typically access a futures market through a broker acting as an agent on a commission
basis. Such brokers are also referred to as futures commission merchants (FCMs). Brokers are members of
the exchange who may offer order execution services (executing broker) or clearing services (clearing broker)
or both. Clearing FCMs are responsible for making margin payments to the exchange for themselves and
their customers, and are subject to higher capital and other requirements.
2 Eurodollar, Euribor, Eurosterling and Euroyen are the most popular instruments used in interest rate futures
contracts. Contracts are usually indexed to the three-month LIBOR rate. On a hypothetical contract in the
amount of $1 million, the contract value changes according to the following formula for every one basis-point
move in the LIBOR rate: $1 million * .01% * 3mos./12mos. = $25.
Market traded Futures exchange.
Common uses • Hedge interest rate risk

• Basic yield curve trades
• Implementation of overall duration view

• Unaffected by creditworthiness of
counterparties, as traded through a
centralised clearing house.
Cons • Higher margin requirement than swaps

• Term adjusted daily, increasing
maintenance needs
• Liquidity may be reduced for longer-
maturity futures
Collateral Depends on the size of the contract and

requirements the characteristics of the underlying asset
(generally 1% to 10% of notional). Daily
margin required for losing position.
Pricing Contracts are marked-to-market and priced

(re-settled) daily on the futures exchange
until the expiration date.
Basic legal • Futures agreement with futures

requirements commission merchant
• Give-up agreements
Currency forward
Counterparties agree to lock in the price of a currency to buy and
sell at a specific future date i.e., to hedge currency risk.
Buys currency at pre-set price
A B
Sells currency at pre-set price

2 A agrees to buy the amount of currency agreed in the

contract from B at a pre-set price. B agrees to sell the
currency to A for the same pre-set price.
3 Contracts are settled in cash on the contract’s expiration date.

Common uses • Hedge undesired currency portfolio

exposure
• Express long or short views on a currency

• Enhances risk management of foreign
investments by hedging currency risk
Cons • Requires frequent adjustment to maintain

effective hedge
• Lighter liquidity in emerging market
currencies versus major currencies
Collateral Yes. Amount depends on characteristics of

requirements underlying currency (generally 1% to 5% of
Pricing Agreed between counterparties at initiation.

requirements1 • Credit Support Annex
• Currency forward confirmation
1 Depending on how the deal is structured, investors can use two alternative sets of legal documentation: an
International Foreign Exchange Master Agreement (IFEMA) together with a currency forward confirmation;
or a Foreign Exchange Prime Brokerage Agreement (FXPB) coupled with an ISDA Master Agreement, Credit
Support Annex (CSA) and give-up agreements with executing brokers.
Which derivative Strategy

is right for your Duration
investment
strategy?
Yield curve
Every type of derivative instrument
offers distinct features, making some
better suited to particular strategies
than others. Country
Credit sector
Corporate security
Currency
Instrument Benefits
• Interest rate futures • Express views on long and

• Interest rate swaps short durations at any maturity
point along the length of
various market yield curves
• Interest rate futures • Take views on steepening or

• Interest rate swaps flattening curve between any
two maturity points
• Interest rate futures • Express views on relative

• Interest rate swaps value between any two
markets at any maturity point
along yield curve
• Credit default swaps • Express views on future

• Government bond futures creditworthiness of particular
market
• Credit default swaps • Distinguish between the

liquidity/credit premium of
various credit sectors
• Credit default swaps • Express both overweight and

underweight investment views
• Total return swaps • Take views on future value of

various credit indices
• Credit default swaps • Express views on individual

• Total return swaps corporate issuers or aggregate
equity indexes
• Currency forwards • Take views on currencies

• Currency options or hedge non-base currency
portfolio exposure
Why Goldman Sachs
Asset Management?
Multi-layered approach
to risk management
Extensive risk management infrastructure within
portfolio teams of Goldman Sachs Asset Management
is complemented by independent control and operational
support at the firmwide level.
• Firmwide Risk Management Groups provide independent
control and oversight of GSAM investment management
activities. They monitor and examine market, credit,
counterparty, liquidity and operational risk via specialist teams.
• The Investment Management Division Risk Committee
establishes and enforces portfolio risk management guidelines,
processes and limits. It engages with portfolio managers
regarding positions and performance on an ongoing basis,
facilitating regular dialogue and interaction among divisional risk
managers, firmwide control functions, compliance and legal.
• Investment Teams adhere to well-defined portfolio
management guidelines and exposure limits. They utilise
proprietary risk management tools developed, enhanced
and implemented within Goldman Sachs’ trading and
brokerage businesses.
Glossary
Over the years, the terminology used in the
derivatives industry has expanded as fast as the
size of the market.
The growing complexity of derivatives instruments
has prompted investment professionals to develop
a series of expressions and acronyms that lends
the industry a language of its own.
This section provides a glossary from Goldman
Sachs Asset Management of the most commonly
used terms in the derivatives markets (and in
this guide).
Basis risk
Risk of a mismatch in price between the hedging instrument and
the underlying asset.
Bilateral
A collateral call by both broker and client.
Collateral
An asset (cash or securities) posted from one counterparty to
another, and held as a guarantee against the value of a specified
portfolio of trades. Commonly referred to as margin, the collateral
also acts to mitigate credit risk.
Collateral call
A demand by a derivatives counterparty for an investor to transfer
cash or securities to collateralise movements in the value of
derivatives contracts.
Confirmation
Statement of all relevant terms and conditions relating to a
particular transaction.
Counterparty
Legal and financial term used to identify a party in a derivatives
contract.
Counterparty risk
Legal and financial term used to identify a party in a derivatives
contract.
Credit event
In the context of a credit default swap, a credit event can include
company restructuring, insolvency or default.
Credit risk
Risk of the borrower defaulting on its obligations.
Credit Support Annex (CSA)
A legal document used to provide credit protection in a derivatives
transaction by establishing the rules governing the mutual posting
of collateral by counterparties. The deal is documented under
a standard contract developed by the International Swaps and
Derivatives Association (ISDA) called the Master Agreement. The
two counterparties must sign the ISDA Master Agreement and
execute a CSA before they can trade derivatives with each other.
Dynamic hedge
A hedging technique which seeks to limit an investment’s exposure
by adjusting the hedge according to changes in the underlying
security. As the value of the underlying moves, new positions can
be taken in options or futures to offset the movement.
Exchange-traded derivatives contracts
Standardised derivatives contracts (e.g. futures contracts and
options) that are transacted on an organised exchange.
Foreign Exchange Prime Brokerage Agreement (FXPB)
A contractual agreement that enables a party to trade with
multiple foreign-exchange forward counterparties under an
ISDA Master Agreement or an IFEMA, while having all positions
held and maintained by one broker/dealer.
Futures Commission Merchant (FCM)
An entity, such as a broker/dealer, that clears and settles
futures trades conducted over exchanges.
Give-up agreement
Agreement between an FCM and an executing futures broker/
dealer, under which the executing broker/dealer agrees to
“give up” the clearing and settlement responsibilities of a

particular trade to the FCM, and the FCM, in turn, agrees to
pay the executing broker a portion of the commission for its
execution services.
Haircut
The specific amount of overcollateralisation that might be
required when a particular asset is taken as collateral.
Independent amount
The amount of collateral that is set aside as a guarantee to the
underlying over-the-counter derivatives contract; generally a
percentage of the notional amount of a derivatives contract.
Initial margin
Upfront collateral requirement that is set aside as a guarantee
to the underlying futures contract; generally a percentage of the
notional amount of a futures contract.
Interest rate swaption
This gives the buyer the option to enter into an interest rate
swap. In exchange for a premium, the buyer has the right, but
not the obligation, to enter into a specified swap with the issuer
on a specified future date.
International Foreign Exchange Master Agreement (IFEMA)
A more customised form of agreement between counterparties
than the ISDA Master Agreement for foreign exchange forward
transactions.
International Swaps and Derivatives Association (ISDA)
This association, which represents participants in the privately
negotiated derivatives industry, is the largest financial trade
association in the world by the number of member firms.
ISDA Master Agreement

A standard contract developed by the International Swaps and
Derivatives Association that establishes the rules by which
counterparties must abide – and the procedures in which
they must engage – when entering a derivatives transaction.
Counterparties must sign an ISDA Master Agreement before
they can trade derivatives with each other.
Liquidity risk
Risk of loss stemming from being unable to unwind a position due
to the unavailability of a willing counterparty to offset the trade.
Margin
Is the amount of collateral required to enter into a derivative
transaction, usually in the context of futures and prime-
brokerage accounts.
Margin call
A demand by a futures exchange or broker that an investor
deposit additional money or securities into his/her margin account
so as to bring it back up to the minimum maintenance margin.
Minimum threshold amount
The minimum amount of exposure that stays uncollateralised.
Minimum transfer amount
A minimum amount applied to avoid the movement of
insignificant collateral balances.
Notional amount
The nominal or face amount that is used to calculate
payments made on swaps and other derivatives instruments.
This amount generally does not change hands and is thus
referred to as notional.
Operational risk
Risk of loss stemming from potential operational flaws (e.g. poor
due diligence, system malfunctions) on the part of a counterparty
in a derivatives contract.
Over-the-counter (OTC) derivatives contracts
Privately negotiated derivatives contracts that are not transacted
in organised exchanges.
Threshold
Amount by which collateral calls are reduced; the amount of
exposure parties are willing to accept.
Unilateral
A collateral call by a broker.
Value at Risk (VaR)
The maximum amount a portfolio will lose over a certain period of
time with a certain probability.
Variation margin
A top up of the cash collateral requirement that may be required
due to adverse movements in the value of the futures contract.
Variance swap
This type of volatility swap gives a payout that is linear to
variance rather than volatility.
Volatility swap
A forward contract where the underlying is the volatility of a
specified product. This allows investors to speculate on how
volatile a stock will be.
Yield curve risk
Risk of loss stemming from shifts in movements in the yield curve.
Source: GSAM, Investopedia.com and the US Department of Treasury (Comptroller of the Currency
Administrator of National Banks).
Learn more
Derivatives are constantly evolving in scope and
complexity. Below is a list of Goldman Sachs publications
that help explain the intricacies of these instruments and
explore their role in modern portfolio management.
• Now is the Time to Consider Hedging Currency Risk

(June 2009)
• Pension Fund and Derivatives: Friend or Foe? (May 2007)
• Using Derivatives to Enhance the Opportunity Set for
Fixed Income Investing (May 2007)
Checkbox
The benefits of using derivatives include:
 Efficient risk management
 Expansion of the investment opportunity set
 High liquidity
 Low transaction costs
THIS MATERIAL DOES NOT CONSTITUTE AN OFFER OR SOLICITATION IN ANY JURISDICTION
WHERE OR TO ANY PERSON TO WHOM IT WOULD BE UNAUTHORISED OR UNLAWFUL TO DO SO.
Prospective investors should inform themselves as to any applicable legal requirements and
taxation and exchange control regulations in the countries of their citizenship, residence or
domicile which might be relevant.
The portfolio risk management process includes an effort to monitor and manage risk, but does
not imply low risk.
GSAM leverages the resources of Goldman Sachs & Co. subject to Chinese Wall restrictions.
Past performance is not indicative of future results, which may vary. The value of investments
and the income derived from investments can go down as well as up. Future returns are not
guaranteed, and a loss of principal may occur.
Opinions expressed are current opinions as of the date appearing in this material only. No part of
this material may, without GSAM’s prior written consent, be (i) copied, photocopied or duplicated
in any form, by any means, or (ii) distributed to any person that is not an employee, officer,
director, or authorised agent of the recipient.
Derivatives often involve a high degree of financial risk because a relatively small movement
in the price of the underlying security or benchmark may result in a disproportionately large
movement in the price of the derivative and are not suitable for all investors. No representation
regarding the suitability of these instruments and strategies for a particular investor is made.
This material has been prepared by GSAM and is not a product of the Goldman Sachs Global
Investment Research (GIR) Department. The views and opinions expressed may differ from
the views and opinions expressed by the GIR Department or other departments or divisions of
Goldman Sachs and its affiliates. Investors are urged to consult with their financial advisors
before buying or selling any securities. This information should not be relied upon in making an
investment decision. GSAM has no obligation to provide any updates or changes.
IMPORTANT NOTICE: In the United Kingdom, this is a financial promotion and has been approved
solely for the purposes of Section 21 of the Financial Services Markets Act 2000 by Goldman Sachs
Asset Management International, which is authorized and regulated in the United Kingdom by the
Financial Services Authority.
Copyright © 2010, Goldman, Sachs & Co. All rights reserved. 34331.OTHER
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4

? Why are they used in investment portfolios?

? What is the difference between swaps, options, futures

? How are different types of contracts commonly used

 Derivatives play an increasingly important role in

Contractual agreements between counterparties 2

The structure and use of derivatives contracts 4

Interest rate swap 7

Total return swap 9

Credit default swap 11

Interest rate and government bond futures 15

Which derivative is right for your investment strategy? 19

Why Goldman Sachs Asset Management? 21

Multi-layered approach to risk management 22

What are derivatives?

Among the most common – and the most liquid – examples

Derivatives are a huge and growing market

Derivatives have evolved into a wide range of financial

Why and how are derivatives used?

 Cost efficiency: transact for minimal cost

 Flexibility: implement investment ideas

 Independence: avoid compromises

 Precision: avoid involuntary risks

 Diversification: gain access to new

There is a wide variety of derivatives available to investors,

General risks of derivative instruments

An investment in derivatives may involve additional

(i) Leverage factors associated with transactions in

(ii) The creditworthiness of the counterparties to such

(iii) The potential illiquidity of specific derivative

Interest rate swap

1 Counterparty A and counterparty B agree on a notional

2 A agrees to pay B a floating rate, typically LIBOR, on the

3 B agrees to pay A a fixed rate on the notional principal amount.

4 At each settlement date, the floating and fixed payments

For illustrative purposes only.

Market traded Over the counter.

Pros • High liquidity

Cons • Not traded in organised secondary

Collateral Depends on the credit quality of the

Pricing Based on the expected value of future

Basic legal • ISDA Master Agreement and schedule

Total return swap

Floating rate + Premium 1

Benchmark Rate of Return 2

1 Counterparty A and counterparty B agree on a notional

2 A agrees to pay B a floating rate, typically LIBOR, on the

3 B agrees to pay A the total rate of return of the agreed

4 At settlement date, payments are netted so that only one

For illustrative purposes only.

Market traded Over the counter.

Credit default swap

1 Protection Buyer and protection Seller agree on a notional

2 Buyer agrees to pay Seller a premium based on the

3 If credit event occurs, Seller pays Buyer the full notional

4 If no credit event occurs during the life of the contract,

For illustrative purposes only.

Market traded Over the counter.

Common uses • Hedge credit risk

Pros • High liquidity

Cons • Not traded in organised secondary market

Collateral Depends on the characteristics of the

Pricing The protection buyer agrees to pay a