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What are credit default swaps?

Definition of 'Credit Default Swaps'.

A credit default swap index is a credit derivative used to hedge credit risk or to take a position on a basket of credit entities. Unlike a credit default swap, which is an over the counter credit derivative, a credit default swap index is a completely standardized credit security and may therefore be more liquid and trade at a smaller bid-offer spread. A credit default swap (CDS) is a financial derivative that is used by a lender to "swap" or offset the risk of a borrower defaulting on a bond or loan. The CDS buyer (lender or bondholder) pays a.

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A credit default swap is a financial derivative that guarantees against bond risk. Swaps work like insurance policies. They allow purchasers to buy protection against an unlikely but devastating event. Like an insurance policy, the buyer makes periodic payments to the seller. The payment is quarterly rather than monthly.

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Credit default swaps CDS are a type of insurance against default risk by a particular company. The company is called the reference entity and the default is called credit event. It is a contract between two parties, called protection buyer and protection seller. Under the contract, the protection buyer is compensated for any loss emanating from a credit event in a reference instrument.

In return, the protection buyer makes periodic payments to the protection seller. In the event of a default, the buyer receives the face value of the bond or loan from the protection seller. A CDS option gives its holder the right, but not the obligation, to buy call or sell put protection on a specified reference entity for a specified future time period for a certain spread.

The option is knocked out if the reference entity defaults during the life of the option. This knock-out feature marks the fundamental difference between a CDS option and a vanilla option. Most commonly traded CDS options are European style options.

Similar to the credit default swaps, CDS options can be: CDS options on a single entity with a regular payoff for the default leg; CDS options on a single entity with a binary payoff for the default leg; CDS options on a basket of entities with regular payoff for the default leg; and CDS options on a basket of entities with a binary payoff for the default leg.

A payer swaption gives the holder of the option the right to buy protection pay premium and a receiver swaption gives the holder of the option the right to sell protection receive premium. In the case of an option on a single-entity, if the reference entity defaults before the option's expiry, the option will be knocked out and become worthless. For an option on a CDIS, when a reference entity defaults before the option's expiry, the loss will be paid by the protection seller to the protection buyer when the option is exercised.

Even if there is only one entity in the portfolio, a CD index swaption is still different from a single-entity CDS option: Credit spread options are options where the payoffs are dependent on changes to credit spreads. The transaction may be either based on changes in a credit spread relative to a risk-free benchmark e. A credit spread option may be a vanilla option or an exotic option, such as an Asian option, a lookback option, etc.

The option style may be European or American. Valuation of credit spread options can be based on modeling the two underlying instruments or modeling the credit spread only. An asset swap is a combination of a defaultable bond with a fixed-for-floating interest rate swap that swaps the coupon of the bond into the cash flows of LIBOR plus a spread.

In the case of a cross currency asset swap, the principal cash flow may also be swapped. In a typical asset swap, a dealer buys a bond from a customer at the market price and sells to the customer a floating rate note at par. The dealer then enters into a fixed-for-floating swap with another counterparty to offset the floating rate obligation and the bond cash flows. For a premium bond, the dealer pays to the customer the difference of the bond price and its par.

For a discount bond, the customer pays to the dealer the difference of the par and the bond price. Synthetic CDOs are credit derivatives on a pool of reference entities that are "synthesized" through more basic credit derivatives, mostly, credit default swaps CDSs and credit linked notes CLNs. A common structure of CDOs involves slicing the credit risk of the reference pool into a few different risk levels.

The level with a higher credit risk supports the levels with lower credit risks. The risk range of two adjacent risk levels is called a tranche. The lower bound of the risk level of a tranche is often referred to as an attachment point and the upper bound a detachment point. The most popular synthetic CDOs are the so-called standardized CDOs sometimes are simply called standardized tranches. For a standardized CDO its reference entities are homogenous, i.

Due to the complexity and the large sizes of reference pools of synthetic CDOs, their valuation is much more complicated and resource intensive than the ordinary single-entity or basket CDSs and CLNs. Monte Carlo methods have been the most reliable methods in CDO valuation but they are not efficient in computation. Recently, thanks in part to the standardization of the synthetic CDO market, quasi-analytic methods, such as the fast Fourier transform FFT , are gaining popularity.

These methods are much more efficient than Monte Carlo simulation for CDOs whose reference entities have "good" homogeneity and, particularly, when the one-factor copula model is used for modeling credit correlation. Correlations are one of the key factors in CDO valuation. Given the spread of a tranche one would like to back out, when the one-factor Gaussian copula model is used, the correlation that gives the tranche's par spread as the given spread.

Such a correlation is called a tranche correlation. Research shows that tranche correlation is not unique except for the equity tranche.

For this reason the implied correlations of tranches that have an attachment of 0 have become more attractive than tranche correlations. Such correlations are known as base correlations. Since market quotes are available only for regular tranches, to back out the base correlations of all trachea of a synthetic CDO, the so-called bootstrapping algorithm must be used.

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It depends on its contract with company A to provide a large payout, which it then passes along to company C.

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In the "no-arbitrage" model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage.

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