Credit Default Swaps

Credit Default Swaps is a type of insurance that prevents a company from the default. In this case, a company is a “reference entity” and the default – “credit event”. The attorney guarantees the compensation of the losses in the case of a credit event. A reference entity transfers regular payments to the insurer account.

3 Ways to Calculate the Size of Payment

There are 3 options payments by the seller to the buyer can be calculated:

  • Fixed cap: A protection seller pays a maximum amount at a fixed rate.
  • Variable cap:  The buyer is compensated by the protection seller for any interest shortfall. and The limit set is Libor plus fixed pay.
  • No cap: The protection seller compensates for a shortfall in interest with no limit.

In the case of default, the CDS purchaser receives compensation. Usually, it makes up the face value of the loan. A bank, in its turn, has to pay off the defaulted debt. Everyone can apply for the CDS even those, who have no insurable interest. Experts call such subjects “naked”.

The real CDS-boom happened at the beginning of the 2000-s. In 2007, the total amount of credit default swaps in the USA made up $62.2 trillion. This number had decreased by the end of 2010 and comprised $26.3 trillion. CDS aren’t traded on the exchange. Furthermore, there is no need to report this transaction to the government party.

The International Swaps and Derivatives Association (ISDA) creates the documented forms of the credit default swaps. Still, it’s possible to use different forms.

There are different types of CDSs such as index CDSs, funded CDSs, loan-only credit default swaps (LCDS), basket default swaps (BDSs), etc.