Credit Default Swaps: Definitions and Types

Four types of credit derivatives you might encounter are total return swaps, credit spread options, credit-linked notes, and credit default swaps. It's that last one that is by far the most common.

In simplest terms, a credit default swap (CDS) is an agreement between two parties. One party is the __credit-protection buyer__ that makes fixed payments to the other party. The other party is the __credit-protection seller__ that promises to pay for credit losses that might occur. What does this sound like to you?

Yes! It's really just an insurance contract. And since it's a contingent payment, contingent on some credit event, it's also correct to think of it like an option contract.

Yes! Since it's a contingent payment, contingent on some credit event, it's very much like an option contract. It's also correct to think of it like insurance.

No. It's not similar to a forward. In a forward contract, both parties know what will be delivered in the future. It's really just an insurance contract. And since it's a contingent payment, contingent on some credit event, it's also correct to think of it like an option contract.

CDS can be based on many borrower types, but corporate borrowers are the most typical. A CDS referencing a single borrower is called a __single-name CDS__, and the single name, like the corporate borrower, is called the __reference entity__. The specifics of the CDS include the debt instrument it covers, called the __reference obligation__. Any obligation of this seniority or greater is covered by the CDS agreement.

Suppose a credit event occurred to trigger payment from the credit-protection seller based on this designated set of bonds. The reference obligation is the issuer's senior unsecured debt. What sort of bond do you think the credit-protection seller would prefer to base the payment on?

No. This would be more expensive than necessary to satisfy the obligation.

Not quite. Think of what you would choose to deliver if you were the credit-protection seller.

Absolutely. That's how it works, much as the credit-protection seller would prefer anyway. The __cheapest-to-deliver__ debt instrument that satisfies the reference obligations is what the credit-protection buyer will get as the CDS payoff. It has to be as senior as the reference obligation, but there's no need to add an extra gift when paying compensation.

Beyond the single-name CDS, there are two other types. One isn't a big deal. It's called a __tranche CDS__, which uses a group of borrowers and separates losses into tranches, just like asset-backed securities. However, a tranche CDS only covers up to a specified amount of losses. But these are a very small part of the CDS market.

The last type, which is a fairly popular form of using multiple borrowers together in a CDS, is the __index CDS__. Market participants can set up positions based on these groups, and so return correlations become important. Suppose that default by one member of this group would drastically increase the probability of default by others. Do you think this would make the CDS protection cheaper or more expensive?

No. This would make protection more expensive.

You got it!

The extent of __credit correlation__ is a big deal for index CDS. If it's high, then think in terms of systemic failures. That's a bigger risk, so insurance will require bigger premiums. Lower credit correlations allow for diversification to make buying credit protection cheaper.

To summarize: [[summary]]

Insurance

An option contract

A forward contract

A senior secured bond

A senior unsecured bond of average value

A senior unsecured bond of the lowest value

Cheaper

More expensive

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