Het Parekh

What is a Credit
Default Swap?
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A credit default swap (CDS) is a

financial derivative that allows two
parties to offset the credit risk of a
reference entity. The buyer of a CDS
makes regular payments to the seller,
and in return, the seller agrees to pay
the buyer the face value of the
reference entity's debt if the
reference entity defaults.
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How Does a Credit Default Swap Work?

A CDS is a contract between two parties:

the buyer and the seller. The buyer of a
CDS is typically an investor who is
concerned about the creditworthiness of
a particular company or country. The
seller of a CDS is typically a bank or other
financial institution that is willing to take
on the credit risk of the reference entity.
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In order to enter into a CDS, the buyer

and seller must agree on the following
terms:
The reference entity: This is the
company or country whose credit
risk is being swapped.
The notional amount: This is the face
value of the reference entity's debt
that is covered by the CDS.
The premium: This is the regular
payment that the buyer makes to
the seller. The premium is typically
expressed as a percentage of the
notional amount.
The maturity date: This is the date
on which the CDS expires.
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What is a Credit Event?

A credit event is an event that triggers the

payment of the CDS. The most common
credit event is default, which is when the
reference entity fails to make a scheduled
payment on its debt. Other credit events
that can trigger the payment of a CDS
include bankruptcy, restructuring, and
repudiation.
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How is a Credit Default Swap Settled?

There are two ways to settle a CDS:

physical settlement and cash
settlement.

In a physical settlement, the buyer

of the CDS delivers the reference
entity's debt to the seller in
exchange for the face value of the
debt.

In a cash settlement, the buyer of

the CDS receives a cash payment
from the seller. The amount of the
cash payment is equal to the
difference between the face value
of the reference entity's debt and
the market value of the debt.
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Example of a Credit Default Swap

Let's say that an investor is concerned

about the creditworthiness of
Company X. The investor buys a CDS
from a bank that agrees to pay the
investor $100 million if Company X
defaults on its debt. The notional
amount of the CDS is $100 million and
the premium is 1%. This means that the
investor pays the bank $1 million per
year for the protection of the CDS.

If Company X defaults on its debt, the

investor will receive a payment of
$100 million from the bank. This will
offset the losses that the investor
would have suffered if Company X had
defaulted on its debt.
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Why are Credit Default Swaps Used?

Credit default swaps are used for a

variety of reasons, including:

To hedge credit risk: Investors can

use CDSs to hedge their exposure
to the credit risk of a particular
company or country.

To speculate on credit risk: Traders

can use CDSs to speculate on the
creditworthiness of a particular
company or country.

To create synthetic credit

products: Banks and other financial
institutions can use CDSs to create
synthetic credit products, such as
credit-linked notes.
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Risks of Credit Default Swaps

Credit default swaps are not without

risk. Some of the risks of CDSs include
:
Counterparty risk: The risk that the
seller of a CDS will default on its
obligations.
Basis risk: The risk that the market
value of the reference entity's debt
will not be equal to the face value
of the debt.
Liquidity risk: The risk that it will be
difficult to buy or sell a CDS.
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Conclusion
Credit default swaps are a complex
financial instrument that can be
used to manage credit risk.
However, it is important to
understand the risks involved
before using CDSs.
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