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Credit Default Swaps (Uses (Hedging: his is the main purpose. For example,…
Credit Default Swaps
Uses
Hedging: his is the main purpose. For example, if an investment bank loaned £10 million to corporate entity at 6%, and they bought a CDS costing 3%, the risk of default of the corporate bond has been transferred from the bank to an insurance company. Therefore the investment bank is guaranteed a risk-free investment of 3%. If the corporate entity defaults, the investment bank would at least have a return of capital
Speculation: a purchaser is hoping that the risk is under-priced and hopes that the reference company will actually default and thus they can call in the insurance. It is not actually a requirement to own debt in order to buy a credit default swap based on that debt
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Originally created in order to allow financial institutions including banks a way of transferring their credit exposure as prior to this there was no means of transferring the risk of default or bankruptcy or other such credit event from one party to another
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Used as vehicles for transferring the risk of default on a particular debt instrument such as a bond from a lender to an insurer (an insurance company or another entity) which is prepared to take on the risk
In exchange for taking on this risk, the insurer will charge a premium
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The transferor does not transfer any of the benefit and is only liable to the extent of the premiums
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Essentially they are contractual agreements providing insurance against the likelihood of a particular entity defaulting on its debt obligation
A company that is the subject of the loan is known as the reference entity. If there were to be default by the reference entity, this would be referred to as a credit event
The buyer of the insurance obtains the right to sell asset issued by the reference company for their full face value in the event that the reference company defaults
The total face value of the bonds that can be sold is referred to as the credit default swaps notional value
The buyer of the CDS will make periodic payments to the seller until either the end of life of the CDS or until a credit event occurs
CDS transfer or swap the risk of default of a debt security from the lender to an insurer. In return for providing this insurance, the insurer will charge a premium; this will vary according to the level of perceived risk. If there is no default,
the insurer will not have to pay and will keep all of the premiums as profit
If the reference company does default, it will depend when default ensues. The insurer will retain the premiums up to default but will generally have to honour the full outstanding commitment whether the full face value of a bond or full loan amount; however, this will of course depend on the terms and conditions
If default occurs, this will be deemed a credit event and the buyer may receive a lump sum payment
Settlement is generally in the form of cash payment or exchanging bonds for their par value. It can be in the form of a cash payment which equates to the bonds market value and par value