What is CDS?
CDS stands for credit default swap; a bilateral over-the-counter derivative contract. It transfers the risk of the loss on the face value of a reference debt issuer over a specified period (underlying asset). The core idea in CDS is to isolate the credit risk from potential default, interest rate and foreign exchange risks. One interesting point, you may enter the CDS contact even if you do not own any credit asset/ reference asset.
The trading mechanism:
When you trade in CDS there are few term which are universal and must be known.
Reference Entity-The corporate or sovereign whose credit risk is transferred.
Term– Time period of the contract/ maturity date.
Notional Amount– Amount of credit (money) being under the contact for protection i.e. $10 million. A standard contact will have $10 million as notional amount.
Premium– The money being paid by the protection buyer to the protection seller. In trading term it is known as “spread”.
Credit Event– An event of default.
Once the protection buyer enters the contact he/she makes timely payments to the protection seller which is called “spread”. The spread is calculated on notional amount of the contact. When the contract ends i.e. at the end of maturity or in case of credit event the buyer stops premium payment aka spread to the seller.
There are two mode of settlement- 1) Physical and 2) cash.
In physical settlement, buyer delivers a basket of deliverable obligations with face value equal to the notional to the seller in exchange of Notional amount ( in simple term buyer has to deliver the bond). While in cash settlement, seller pays notional minus price assigned to the reference obligation ( in simple term seller will pay notional minus recovery rate aka existing spread on the CDS).
To make it more clear, lets assume you buy a protection on $10mln at 100 bps. Now the next day spread widens to 150 bps. So, in mark to market term you made a profit of :
$10mln* (0.0150-0.0100)*4.10= $205,150
Notional amount*(change in spread)*spread PV01
Note: Spread PV01 is the change in CDS value caused by a 1basis point of spread move; a tedious calculation. Spread PV for particular CDS are available in many financial databases.
Tomorrow we will have calculation of spread PV and CDS pricing in detail. Keep reading!