Credit Default Swaps (CDS)
1 INTRODUCTION
For the past decade, we have witnessed a new, sophisticated and increasingly popular
development in the derivatives market – credit derivatives. Instead of the normal
derivatives where prices are dependent on prices of underlying asset, credit
derivatives are instruments where the evaluation of options are driven by the credit
risk of commercial or government entities. These credit derivatives are also part of a
group of options known as exotic options.
Credit derivatives market has been developing at a very fast pace. According to
forecasts from the British Bankers' Association, the credit derivatives market grew
from USD 40 billion outstanding notional value in 1996 to about USD 1.5 trillion in
year 2002.
Credit derivatives can be broadly classified into 3 main categories - total return swap,
credit default swap (CDS) and credit linked notes. In this paper, we shall examine
credit default swaps and cover the features and functions of CDS in Section 2, trading
perspectives of CDS in Section 3 and finally, an overview of the CDS market in
Singapore in Section 4.
2 CREDIT DEFAULT SWAPS (CDS)
2.1 What is a CDS?
A CDS is a privately negotiated bilateral contract between two parties. It is a contract
that provides one party the insurance against the risk of default by a specified
company known as the ‘reference entity’. The buyer of protection pays a fixed
premium (CDS spreads) to the seller of protection for a period of time and obtains the
right to be compensated when there is a ‘credit event’1. If no credit event occurs, the
buyer will continue to pay the premium until maturity. However, if the credit event
occurs, the seller owes a payment to the buyer of ...