| Credit Default Swap 101 |
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| 17/04/2005 | |
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1-What is a Credit Default Swap (CDS)? A CDS is a credit derivative instrument that protects its buyer from a credit default. It involves two parties, a protection buyer and a protection seller, and one underlying security. The protection buyer pays the protection seller a fixed premium at regular intervals over a predetermined period and is in turn protected in the event of a default during that period. Two situations can occur. Either the bond matures without the issuer defaulting, in which case the contract ends without further cash flowing from one party to the other, or the underlying bond issuer defaults, in which case the protection seller has to buy back the defaulted bond at its par value and the payment of the premium is stopped. As such, a CDS works as an insurance contract for the protection buyer, who unloads the default risk on the protection seller. CDS are traded as OTC contracts and can have various maturities, though a five-year maturity is the most common. CDS are also a useful indicator of future spread as they price in the investors' expectations of future risk. 2-What is the state of the market in CDS? The CDS is the most common instrument on the credit derivative market, accounting for roughly two-thirds of the market according to Fitch Ratings. According to Fitch's numbers, the gross notional outstanding of CDS increased 100% to $1.9 trillion in 2004. "Growth accelerated in 2004, coinciding with the successful launch of the traded indices, an active market for synthetic collaterized debt obligations (CDOs), increased interest in high yield CDS names, and the growing use of CDS as a trading instrument for hedge funds and the inter-dealer community", reported Fitch Ratings' analysts, adding that this had resulted in a tightening of the bid-offer spread This upward trend followed a serious downturn in 2002 due to heightened credit risk (WorldCom defaulted in the summer 2002), which induced many traditional protection sellers such as insurers to reduce the issuance of credit protection. In turn, even if the market has then improved, protection buyers still often outnumbered protection sellers at the third quarter of 2004, according to Fitch. 3-What kind of investors are CDS designed for? CDS appeal to all investors who have an exposure to the fixed-income market. Among the most active protection buyers are banks – which represent about half of the demand according to the British Bankers Association (BBA) – as well as security houses and hedge funds which have been increasing their importance on the market, notably for speculative purposes. Banks are strongly represented on the sell side, but the institutions surveyed by the BBA expected insurance companies to overtake them in 2004. |
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