CRDIT DEFAULT SWAP

Credit default swap is a swap designed to transfer the credit exposure 0f fixed income products between parties. It is the most widely used credit derivative. The buyer, who is called protection buyer, transfers the credit risk , to the protection seller, without transferring the title to the underlying asset. The buyer pays a periodic fee, in return for a contingent payment by the seller upon a credit event happening in the reference entity. The credit events that will trigger payment by the protection seller are ; I) ii iii) iv ) v) Bankruptcy Failure to pay Repudiation/moratorium Restructuring Obligation default/acceleration.

Most CDS contracts are settled physically. These are generally used for the following purposes : To reduce capital required to support credit risk exposures To release credit exposure limits to counterparty To reduce concentration to a particular counterparty or sector To fill the gaps in credit quality spectrum The other features of a CDS are : The buyer of a CDS need not own the underlying security ; this is called naked CDS The seller need not be a regulated entity The seller is not required to maintain any reserves to pay off buyers. The main risk associated with CDS is that a creditor after lending certain amount to a debtor company can purchase CDS many times the value of the loan, it can also purchase without possessing any asset. Thus the creditor has an incentive to have the debtor company fail. Further if the creditor is fully hedged, there will be little incentive to formulate a restructuring plan.