Credit Default Swaps

Protection

The buyer gets ‘protection’ on credit risk of the issuer. The seller acts as an insurer for the notional value of the CDS. The seller gets the premium and that is the maximum revenue that the seller of the protection gets.

Credit risk

The credit risk forms the subject matter of this insurance contract. ISDA enlists certain events as credit events, the occurrence of which triggers the termination of the contract.

Bilateral contract

The CDS contract has two parties the buyer of protection and the seller of protection. The contract is done over-the-counter (OTC).

Reference entity

The Issuer of the fixed income security on which protection is bought and sold is known as the Reference entity. The Reference entity could be a corporate entity or it could be a ‘Country’.

Reference Obligation

The specific security on which the protection is bought and sold is known as the ‘Reference Obligation’. The terms of the reference obligation are spelt out in the contract – for example, senior, senior-secured, senior-unsecured etc.

Protection buyer

The ‘Protection buyer’ pays a fixed premium on a quarterly basis to the protection seller and the premium is all that has to be paid by the buyer of protection. The protection buyer is the insured.

Protection seller

Effectively the ‘Protection seller’ is the insurer. The protection seller lodges a percentage of the underlying with the protection buyer as collateral for the transaction. This partially ensures that the protection seller is in a position to fulfill his obligation when the credit event occurs.

Credit events

The ISDA agreement specifies the standard credit events and the specific CDS contract will specify which credit events are covered in the particular contract.

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