Credit Default Swap - A Credit Derivative Instrument

Credit Default Swap (CDS): - Credit Default Swap can be defined as the transfer of credit risk from one party to another. It is basically when a party called ‘A’ purchase the protection against the credit given to other party called ‘B’ from the third party called ‘C’. There are certain credit derivative processing companies who sell the credit protection and, in return get the monthly, quarterly or annual premium amount for the same e.g. Primus Financial. If we talk in terms of Primus, the party to whom Primus is giving the credit protection will be counterparty for Primus and the party against which the protection is given will be reference entity for Primus. The party which is buying the protection will be considered in short position as it is shorting its credit risk. Similarly party which is selling the protection will be considered in long position as it is expanding its credit risk.

In a standard CDS contract party ‘A’ purchases credit protection from the party ‘C’, to cover the loss of the face value of an asset following a credit event. A credit event is a legally defined event that includes bankruptcy, failure to pay and restructuring. The contract lasts for some specified date known as Maturity Date. Under the contract party ‘A’ will pay premium (on monthly, quarterly or annually basis) to the Party ‘C’ until the maturity date or credit event, whichever comes first. In case if credit event occur before the maturity date party ‘C’ will pay to the party ‘A’. The payment which protection seller has to pay to the protection buyer to compensate protection buyer loss will be equal to the difference between the par value of the credit asset (which party ‘B’ or reference entity has taken from the party ‘A’) and its market value at the time of credit event. Two ways are used to settle the payment in case of credit event. The payment mode is selected at the start of the contract.

1. Physical Settlement
2. Cash Settlement

1. Physical Settlement: - In physical settlement method, in case of a credit event, the payment which protection seller has to pay to its counterparty to compensate counterparty’s loss will be equal to the par value of the credit asset at the time of credit event. In this case counterparty delivers the defaulted credit asset to the protection seller in return of the compensation paid by the protection seller. Protection seller can recover its loss by selling the defaulted credit assets. Contract terminates, once the compensation is paid by the protection seller to its counterparty, for that particular deal for which the compensation is paid.

2. Cash Settlement: - In cash settlement, in case of credit event, the payment which protection seller has to pay to its counterparty to compensate counterparty’s loss will be equal to the difference between the par value of the credit asset and its market value at the time of credit event. In this case defaulted credit assets remain with the counterparty. Contract terminates, once the compensation is paid by the protection seller to its counterparty, for that particular deal for which the compensation is paid.