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A credit default swap (CDS) contract is an agreement to exchange a specified set of coupon payments in return for the right to receive the par face value of a reference obligation after the particular obligor undergoes a credit event. The parties involved in the contract are a protection buyer, who pays the coupons or premiums (usually quarterly), and a protection seller, who receives the premiums, but must pay the buyer the par value of an eligible security in exchange for that security in the event of a default, bankruptcy, or restructuring.1
In more recent versions of the standard CDS contract, the protection buyer makes an upfront payment set by the seller and pays a standard running 100 bp or 500 bp premium that depends on the riskiness of the reference obligor. (Even for the new contract, the upfront cash flow and fixed spread premium can be converted to an effective spread premium). The CDS contract is usually obligor-specific, referring to either a corporate or sovereign entity. The securities that are eligible for delivery to the protection seller in event of default, the reference obligations, are typically from a single class of debt (unsecured bonds, loans, or subordinated bonds, etc.), but can be asset specific.
For most purposes, both the CDS contract with upfront payment and standard coupon and that with no upfront payment and market-based coupons can be represented using the diagram in Exhibit 1 . The exhibit shows an example of a CDS written on $10 million of notional with reference to firm XYZ. The buyer of protection makes quarterly payments, the premium leg, for as long as there is no credit event or until the maturity of the contract, whichever comes first. The CDS premium, even if trading with constant coupon and upfront fee, is often expressed as an annual amount in basis points. Also, contracts from a given firm are commonly issued at a number of standard maturities, with the most common term being five years. The protection seller agrees to pay the buyer the face value of the CDS contract if XYZ undergoes a credit event and the buyer of protection delivers to the seller the defaulted security or its cash equivalent.2
The advantages of having a liquid credit...