Credit default swap - CDS

What is a credit default swap? A credit default swap (CDS) is a form of insurance against possible default of payment on an underlying debt, for example, a loan or a bond, by a defined entity. This entity can be a publicly traded or private firm, a sovereign government, a supranational or an index.

It is a basically an agreement between the protection (or insurance) buyer and the protection seller. The protection seller promises to compensate the protection buyer in the event of a predefined default event by the bond or loan issuer. In return the insurance buyer pays a regular fixed payment (or premium) for the duration of the protection period, or up to a default event.

Note The predefined event is not limited to a payment default. It can include other events, e.g., postponed coupon payments, bankruptcy, etc.

This fixed payment (which is in effect the price of buying the protection) is known as the breakeven CDS spread. This is a bid/ask price in basis points, where a basis point is 0.01 percent of the notional value of the deal.

In SD-CD it is displayed as soon as you enter the tenor of the CDS, and is shown both as a mid price and as a bid/ask price.

The size of the CDS spread is a reflection of two factors:

• Default probability
  That is, how probable it is that the issuer will default on its obligations.
• Recovery rate
  That is, if the issuer defaults on its obligations, how much will a bondholder recover without having credit protection.
  A wider spread indicates that investors believe a default is more likely.

In SD-CD you can see this data (i.e., the mid spread, default probability and the recovery rate) in the CDS Spread Curve page (this page is available by clicking the CDS Spread Curve tab in the left-hand side toolbar).

In the event of a default event, the protection buyer receives a payoff which is the difference between the face value and the market value of the underlying debt minus the premium which has accrued since the last payment was made. So continuing the example above, whereby an investor will only receive 30 cents from the defaulting company, if this investor had entered into a CDS the protection buyer will cover the other 70 cents of each dollar owed.