Functioning of Credit Default Swaps:
- A credit default swap (CDS) is a credit derivatives instrument that provides insurance to the buyer [Protection Buyer] against the risk of a default by a particular company [Reference Entity].
- The fundamental role of credit default swaps is to transfer credit risk between a party wishing to reduce credit risk, often called the protection buyer, risk seller or risk hedger (the party going short the credit), and the party wishing to acquire or hold credit risk, often called the protection seller or risk buyer (the party going long the credit).
- Each CDS has a notional amount and it requires the buyer to pay a premium called CDS spread.
- The credit event is binary in nature, i.e. it occurs, or it doesn’t.
- Typical credit events include (a) a filing for bankruptcy by the third party on whose bond the CDS was issued, (b) any failure by the third party to pay interest on its bonds, and (c) any restructuring of the Debt.