CREDIT DEFAULT SWAPS Sabina Chauhan CREDIT DEFAULT SWAPS

CREDIT DEFAULT SWAPS Sabina Chauhan

CREDIT DEFAULT SWAPS • In a credit default swap, the buyer of the swap makes payments to the swap’s seller till to the maturity date of a contract. • In return, the seller agrees that, in the event of default of the debt issuer, the seller will compensate the loss for the buyer and pay the security’s premium as well as all interest payments that would have been paid between that time.

• To illustrate, suppose Bob holds a 10 -year bond issued by company XYZ with a par value of Rs 10, 000 and a coupon interest amount of Rs 100 each year. Fearful that XYZ will default on its bond obligations, Bob enters into a Credit Default Swaps(CDS) with Steve and agrees to make him a payment of Rs 20 each year, If XYZ fail to meet its obligation, Steve agrees to pay Bob the Rs 10, 000 par value of the bond in addition to any remaining interest on the bond (Rs 100 multiplied by the number of years remaining). If XYZ fulfills its obligation on the bond through maturity after 10 years, Steve will make a profit on the annual Rs 20 payments.

BENEFITS CDS • the buyers can remove risky entities from their balance sheets without selling them • the sellers can gain higher returns for taking risk and also allow sellers to enter into the derivative markets which are otherwise difficult for them to get into.

TYPES OF CDS • Credit default swaps on single entities: In this form, the swap is on a single entity • Credit default swaps on a basket of entities: In this form, the swap is on a bunch of entities combined together

FORM OF SETTLEMENTS OF CDS Cash settlement: seller pays the difference between amount default less any amount recovered Physical settlement: seller delivers the reference good or instruments. Fixed settlement: seller pays the fixed amount regardless of the loss.