Saturday 26 May 2012

Credit default swap


A Credit Default Swap (CDS) is now a days one of the most widely traded form of credit derivative, it's one more example of Hedging tool. It is similar to an insurance contract, providing the buyer need to pay to buy (insurance) protection from another party for losses that may occur as a result of the ( loan, sovereign debt, company bond ) default, bankruptcy or credit rating downgrades.

The "buyer" of protection pays a fixed fee or premium for the protection, and in return, the "seller" of protection promises to make a payment equal to the losses incurred upon the occurrence of credit events

The "buyer" of protection = XXX Bank 
The "seller" of protection = YYY Insurance Company 
Suppose Bank XXX buys corporate bonds issued by a IT Company ZZZ.
In order to hedge the default risk of ZZZ, Bank XXX buys a CDS from Insurance Company ZZZ.
XXX pays a periodic fee to ZZZ, in exchange for a credit default protection
In return, ZZZ agrees to pay XXX a set amount if a credit default event occurs.







No comments:

Post a Comment