A credit derivative separates credit risk and transfers it between the parties. The cornerstone product of the credit derivative market is the credit default swap (CDS). It is simply an exchange of a fee in exchange for a payment if a credit default event occurs.

The protection buyer is the counterparty in a CDS transaction that purchases the credit protection. The protection seller sells the credit protection in such a transaction. It is able to invest in credit risk without having to fund the transaction. Note that:

• A protection buyer is a seller of credit risk.
• A protection seller is a buyer of credit risk.

The reference entity is the borrower, and the reference obligation is the debt instrument issued by the borrower that is being covered. It can be a loan, a bond, sovereign risk or credit exposure due to derivative contracts.

The notional amount of a CDS is the amount of protection being purchased.

Example

A pension fund owns $10 million worth of a five-year bond issued by Risky Corporation. In order to manage their risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million which trades at 200 basis points. In return for this credit protection, the pension fund pays 2% of 10 million ($200,000) in quarterly installments of $50,000 to Derivative Bank.

If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million loan back after 5 years from the Risky Corporation. Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario is eliminated.

If Risky Corporation defaults on its debt 3 years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million (either by taking physical delivery of the defaulted bond for $10 million or by cash settling the difference between par and recovery value of the bond).

Another scenario would be if Risky Corporation's credit profile improved dramatically or it is acquired by a stronger company after 3 years, the pension fund could effectively cancel or reduce its original CDS position by selling the remaining two years of credit protection in the market.

Types of CDS

There are three types of CDS:

• Single-name CDS: the CDS is on one specific borrower. The designated instrument is usually a senior unsecured obligation. The payoff of the CDS is determined by the cheapest-to-deliver obligation: the debt instrument that can be purchased and delivered at the lowest cost but has the same seniority.

• Index CDS: the CDS involves a combination of borrowers. The key determinant of the value is credit correlation.

• Tranche CDS: it covers only up to pre-specified levels of losses.

CDS Spread

The protection buyer pays a periodic premium, the CDS spread, to the protection seller. It is usually calculated as basis points of the notional amount.

The CDS rates are now standardized. The most common rates are 1% (for a CDS on an investment-grade company) and 5% (high-yield company). An upfront premium is calculated because not all investment-grade companies have equivalent credit risk, and not all high-yield companies have equivalent credit risk.

• The premium is converted to a present value basis.
• If the standard rate < the credit spread, the protection buyer will make the upfront payment.
• If the standard rate > the credit spread, the protection seller will make the upfront payment.

The reference entity's credit quality may change later.

• The protection buyer benefits if the credit quality deteriorates.
• The protection seller benefits if the credit quality gets better.

The gains and losses are reflected in the market price of the CDS.