Credit default swaps

A study of credit derivatives, in the FRM, begins with the default swap. More specifically, a single-name credit default swap (CDS). A single-name CDS protects against a single asset (e.g., a bond); a basket CDS gives protection against several assets. The CDS is like a credit insurance agreement between two parties. The investor (the protection buyer) may own a bond asset and seek to "insure" its default risk.

The investor pays the spread (akin to periodic insurance premiums) to the protection seller. If the loan never defaults, the protection buyer has lost the stream of spread payments over the swap's tenor. We could liken this to an investor (the protection buyer) purchasing a put on the reference asset; without a default, the put goes unexercised and the investor loses the put premium.

If the reference asset (the bond) does default, the CDS seller pays cash to the buyer. The cash paid will be either net of recovery or the full par value of the asset:

* If the CDS is cash-settled, the seller pays the difference between the par value of the reference asset and the recovery (market value of the defaulted bond).
* If the CDS is physically-settled, the CDS buyer delivers the defaulted asset to the CDS seller and the CDS seller pays the full par value in cash

The CDS buyer does not need to own the reference asset! Note that if the CDS buyer does not own the asset, he/she assumes additional risk with physical settlement: the CDS buyer will need to retrieve the asset for delivery to the CDS seller (Via Bionic Turtle).