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Meaning of a Credit Default Swap

What is a Credit Default Swap?

  • A Credit Default Swap (CDS) is a form of protection against credit risk
  • CDS is a bilateral contract where by the credit risk of a reference entity (the issuer) is transferred from the protection buyer to the protection seller
  • The protection buyer pays a fixed premium to the protection seller in return for a contingent payment, which compensates the protection buyer from any loss incurred in case of a credit event
  • A negative credit event (default by a third party) is usually pegged to an obligor’s performance on a reference obligation, like a bond or a loan
  • The standard corporate credit events are bankruptcy, failure to pay, restructuring etc.
  • CDS documentation is governed by the International Swaps and Derivatives Association (ISDA)
  • ISDA Agreement provides standard definitions of credit default swaps terms, viz., reference obligation, credit event, reference entity and premium and so on
  • CDS are traded over-the-counter (OTC). Standardization of CDS has made the credit default swap much more attractive to the customers in spite of being an OTC product
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