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An investor with a long or short position in an existing credit-default swap can monetise a change in the default swap premium, and realize profit and loss, in three ways:
* Agreeing an unwind payment with the original default swap counterparty in termination of the transaction.
The investor receives or pays the current mark-to-market value of the existing default swap from or to the current default swap counterparty. One of the benefits of 'tearing up' an existing trade is that all future cashflow streams are cancelled and ongoing legal risk (i.e. possible disputes over deliverable obligations) is removed. This method also has potentially advantageous capital treatment.
* Assignment to another counterparty. A less common method for unwinding credit-default swaps is to assign the existing swap to a third party and receive or pay the current mark-to-market value from or to the third party. This depends on there being an attractive market price for the existing default swap (made more unlikely if the existing swap has an irregular amount of time outstanding). It will also be subject to the protection buyer agreeing to take on the counterparty risk of the protection seller. Again this may reduce legal or capital risk for the investor who has closed their position.
* Entering into an offsetting transaction. The final alternative is to enter into an offsetting long or short protection position with another counterparty. Offsetting transactions are not as popular with end investors as they require the signing of further documentation and added legal risk. Nonetheless, unwinding with another counterparty may be the most desirable option for holders of illiquid positions where better unwind terms may be available away from the original counterparty.
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