Description
(CDS) is a contract in which a buyer pays a payment to a seller to take on the credit risk of a third party. The ppt covers the topic in detail.
Credit Default Swaps
• A Credit Default Swap (CDS) is a contract in which a buyer pays a payment to a seller to take on the credit risk of a third party. In exchange, the buyer receives the right to a payoff from the seller if the third party goes into default or on the occurrence of a specific credit event named in the contract (such as bankruptcy or restructuring).
•
To give an example…
• Say there is a person A who lends Rs. 1000 to person B on Monday. Person B promises to pay him back on Friday. But there is a possibility that person B may default in paying back person A in the event of a bankruptcy etc.
• Therefore, person A gets into a contract with a person C to take over the credit risk of this transaction, in case person B defaults. • According to the contract, person A pays a one-time premium of Rs. 100 to person C.
Now, imagine two situations…
• Situation A: Person B pays back Rs. 1000 to person A. Since person B has not defaulted, the transaction ends between persons A & B, and also between persons A & C.
• Situation B: Person B defaults in his payment to person A. Now, according to the contract between persons A & C, It becomes the obligation of person C to pay back Rs. 1000 to person A.
Person B (Borrows Money from A)
Person C (takes on the credit risk of B)
Person A (lends money to B & enters into a contract with C)
Therefore…
• This contract, which: – Transfers the ‘credit’ risk from one person to another – Is exercised when one party ‘defaults’ in its payment – Consists of a ‘swap’ of a buyer and a seller (in our example, person A is a seller to person B and a buyer to person C) is called a Credit Default Swap.
Now…
• One party of the CDS contract is called the protection buyer while the other party is called the protection seller. • Protection Buyers are mostly banks and financial institutions but Protection Sellers could be anybody with an appetite for risk, such as hedge funds and insurers in the US. • In all CDS contracts, a protection buyer transfers his Credit Risk of a third party transaction to a protection seller.
So…
• A credit default swap resembles an insurance policy. You pay the premium and the insurance company undertakes to make good your loss.
• So, everything depends on the happening of the credit event. If no default occurs then the protection seller would not make any payment.
• A Credit Default Swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" pays periodic payments to the "seller" in exchange for the right to a payoff if there is a default or credit event in respect of a third party.
• They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others.
• Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.
doc_373953330.pptx
(CDS) is a contract in which a buyer pays a payment to a seller to take on the credit risk of a third party. The ppt covers the topic in detail.
Credit Default Swaps
• A Credit Default Swap (CDS) is a contract in which a buyer pays a payment to a seller to take on the credit risk of a third party. In exchange, the buyer receives the right to a payoff from the seller if the third party goes into default or on the occurrence of a specific credit event named in the contract (such as bankruptcy or restructuring).
•
To give an example…
• Say there is a person A who lends Rs. 1000 to person B on Monday. Person B promises to pay him back on Friday. But there is a possibility that person B may default in paying back person A in the event of a bankruptcy etc.
• Therefore, person A gets into a contract with a person C to take over the credit risk of this transaction, in case person B defaults. • According to the contract, person A pays a one-time premium of Rs. 100 to person C.
Now, imagine two situations…
• Situation A: Person B pays back Rs. 1000 to person A. Since person B has not defaulted, the transaction ends between persons A & B, and also between persons A & C.
• Situation B: Person B defaults in his payment to person A. Now, according to the contract between persons A & C, It becomes the obligation of person C to pay back Rs. 1000 to person A.
Person B (Borrows Money from A)
Person C (takes on the credit risk of B)
Person A (lends money to B & enters into a contract with C)
Therefore…
• This contract, which: – Transfers the ‘credit’ risk from one person to another – Is exercised when one party ‘defaults’ in its payment – Consists of a ‘swap’ of a buyer and a seller (in our example, person A is a seller to person B and a buyer to person C) is called a Credit Default Swap.
Now…
• One party of the CDS contract is called the protection buyer while the other party is called the protection seller. • Protection Buyers are mostly banks and financial institutions but Protection Sellers could be anybody with an appetite for risk, such as hedge funds and insurers in the US. • In all CDS contracts, a protection buyer transfers his Credit Risk of a third party transaction to a protection seller.
So…
• A credit default swap resembles an insurance policy. You pay the premium and the insurance company undertakes to make good your loss.
• So, everything depends on the happening of the credit event. If no default occurs then the protection seller would not make any payment.
• A Credit Default Swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" pays periodic payments to the "seller" in exchange for the right to a payoff if there is a default or credit event in respect of a third party.
• They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others.
• Like most financial derivatives, credit default swaps can be used to hedge existing exposures to credit risk, or to speculate on changes in credit spreads.
doc_373953330.pptx