The concept of credit default swap has a substantial amount of importance in the financial market. A credit default swap (also known as CDS) is basically a two-sided agreement. In this agreement, the two parties to the contract accord on isolating and distinctly trading the credit risk of minimum one referred third party organization.
In case of a credit default swap contract, a periodical fee is paid by a protection purchaser to a protection seller in substitution of a contingency defrayal from the seller depending on a credit event. For example, failure or default in payment that occurs on the referred organization.
At the time the credit event actuates, the protection seller has two options. Either he can receive the delivery of the bond in default at the face value or par value (which is termed as physical settlement) or he has the option to pay the margin between the recovery value and the face value of the bond (which is termed as cash settlement).
The credit default swaps bear similarities with insurance policies simply because of the reason that insurance policies can be implemented by the borrowers for the purpose of hedging the credit events.
Nevertheless, as there is no necessity to retain an asset or bear a loss, the credit default swaps might be utilized for speculating on the variations in credit spread.
The credit default swaps form the majority of credit derivative products that are traded in the financial market. Basically, the term period of a credit default swap agreement is 5 years, despite the fact that credit default swaps are over-the-counter derivatives, their trading is done on various types of maturity period.
A credit default swap agreement is usually authenticated according to the approval with reference to the 2003 Credit Derivatives Definitions as promulgated by the International Swaps and Derivatives Association.
The approval particularly defines a reference organization as a sovereign body or corporation that commonly, but not everytime has outstanding debt and reference obligation is commonly defined as an unsubordinated government bond or corporate bond. The different dates involved in the extension of the default protection are the scheduled termination date and the effective date.
The credit default swap agreements are sold by providing par value quotes or par quotes.
For the purpose of pricing of credit default swaps, two contesting models or theories are implemented. The first one is known as the probability model and the second one is basically a non-arbitrage based model conceptualized by Darrell Duffie, Hull and White.
Credit default swaps are principally used in hedging and speculation transactions.
Last Updated on : 1st July 2013