A credit default swap is probably the simplest form of credit risk transference among all credit derivatives.

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By far, the most popular type of credit derivative is the credit default swap. Not only is this form of credit derivative the most commonly used standalone product employed by asset managers and traders, but it is also used extensively in structured credit products such as synthetic collateralized debt obligations and credit-linked notes. A credit default swap is probably the simplest form of credit risk transference among all credit derivatives. Credit default swaps are used to shift credit exposure to a credit protection seller.

Basic Elements

In a credit default swap, the documentation will identify the reference entity or the reference obligation. The reference entity is the issuer of the debt instrument. It could be a corporation, a sovereign government, or a bank loan.

When there is a reference entity, the party to the credit default swap has an option to deliver one of the issuer’s obligation subject to prespecified constraints. So, if the reference entity is Ford Motor Credit Company, any one of acceptable senior bond issues of that issuer, for example, can be delivered. In contrast, a reference obligation is a specific obligation for which protection is being sought.

Credit default swaps can be classified as follows: ■ Single-name credit default swaps ■ Basket swaps

In a credit default swap, the protection buyer pays a fee, the swap premium, to the protection seller in return for the right to receive a payment conditional upon the default of the reference obligation or the reference entity. Collectively, the payments made by the protection buyer are called the premium leg; the contingent payment that might have to be made by the protection seller is called the protection leg.

In the documentation of a trade, a default is defined in terms of a credit event and we shall use the terms “default” and “credit event” interchangeably throughout this book. Should a credit event occur, the protection seller must make a payment. This is shown in above picture.

Calculation of the Swap Premium

The standard contract for a single-name credit default swap in the interdealer market calls for a quarterly payment of the swap premium. Typically, the swap premium is paid in arrears.

The quarterly payment is determined using one of the day count conventions in the bond market. A day count convention indicates the number of days in the month and the number of days in a year that will be used to determine how to prorate the swap premium to a quarter. The possible day count conventions are (1) actual/actual, (2) actual/360, and (3) 30/360. The day count convention used in the U.S. government bond market is actual/actual, while the convention used in the corporate bond market is 30/360. The day count convention used for credit default swaps is actual/360. This is the same convention used in the interest rate swap market. A day convention of actual/360 means that to determine the payment in a quarter, the actual number of days in the quarter are used and 360 days are assumed for the year. Consequently, the swap premium payment for a quarter is computed as follows:

Quarterly swap premium payment = (Notional amount) × 
(Annual rate (in decimal)) × 
(Actual number of days in quarter)/360