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credit_default_swaps - U NIVERSITY OF E SSEX D EPARTMENT OF...

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U NIVERSITY OF E SSEX D EPARTMENT OF E CONOMICS EC372 Economics of Bond and Derivatives Markets Credit Default Swaps 1. Credit Default Swaps: basic ideas Just as for any OTC contract, the terms of a Credit Default Swap , CDS, are at the discretion of the parties to the contract. The CDSs described below are of the simplest ‘plain vanilla’ type, which probably describes a large majority of such swaps, especially since mid-2008 (when the onset of the credit crisis resulted in greater caution in the design of derivative securities). The two parties, A and B , to the CDS agree to make payments to one another according to the payoffs on a credit instrument, typically a bond, issued by a reference entity , C a company or sovereign state, which is not a party to the swap. The C -bonds are risky inasmuch as C might renege on some aspect of the bond indenture, e.g. fail to make coupon payments or to repay the face value (principal) at maturity. Such a failure to comply with the C -bond indenture is termed a credit event , i.e. ‘default’ of C . The actions that comprise the CDS are as follows: 1. One party, say A – the ‘buyer’ (or ‘long’) – agrees to make regular payments (say, every three or six months) to B for a specified period, typically until the C -bond is redeemed at maturity. 2. Party B – the ‘seller’ (or ‘short’) – pays nothing to A unless or until a credit event occurs for the C -bond, at which time B makes a one-off payment to A thus terminating the CDS. Typically the one-off payment from B to A is the face value of the C -bond, in return for which A delivers the C -bond to B , i.e. effectively B buys the C -bond from A at its face value . Alternatively, the CDS may be cash-settled: B pays to A the difference between the face value and the market value of the C -bond (which may be zero) shortly after the credit event . For binary CDS the payment following a credit event is an agreed fixed sum, irrespective of the market value of the C -bond following a credit event . Thus a CDS can be interpreted as an insurance contract, with A (the ‘insured’) paying pre- miums to B – the ‘insurer’ – against the contingency of ‘default’ on the C -bond. However, the CDS is stand-alone in the sense that A is not obliged to own the C -bond – A may simply use the CDS to make a bet that C -bond will default (with B betting that it will not). Although the CDS contract will include clauses that seek to characterise the circum- stances that define a relevant credit event , some ambiguity almost certainly remains – the CDS is an incomplete contract . That is, swap agreements are inevitably incomplete . What happens if, for example, C merely delays a contractual payment (say, a coupon) rather than defaults outright? Or perhaps C is a company that is able to restructure its liabilities, in ne- gotiation with its creditors, to avoid bankruptcy? (The ‘restructured’ C -bonds will continue Page 1 of 4 (revised 16/09/2011)
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to exist but with different – presumably lower – contractual payoffs.) The CDS contract
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