Buying protection
Paying the premium on a credit default swap in return for a payout on a credit event: a short credit position that gains when spreads widen. Selling protection is the opposite, long credit.
Where you will meet it
Buying protection appears in 6 learning outcomes on the CFA syllabus. A few of them:
- Set out what credit derivatives are and their main features
“The protection buyer pays a periodic premium, the CDS spread, to the protection seller; if a credit event occurs, such as bankruptcy, failure to pay or a qualifying restructuring, the seller compensates the buyer for the loss, by physical or cash settlement.”
- Explain credit default swaps (CDS), covering index CDS as well as single-name CDS, and the terms that specify a particular CDS contract
“A credit default swap transfers the credit risk of a reference entity from the protection buyer, who pays a periodic premium, to the protection seller, who pays out if a credit event occurs.”
- Explain how credit default swaps can be used in an actively managed fixed-income portfolio
“The CDS protection buyer pays a periodic premium and is compensated if the reference entity defaults; the seller takes on credit risk without funding a bond.”
- Explain the principles behind how the market prices CDS and the factors that affect that pricing
“After the trade, for the protection seller, value change ≈ minus (change in spread × duration × notional), and the sign reverses for the protection buyer, who gains when spreads widen.”
See also
Credit default swap · Credit event
Practise it
Practise buying protection until it is automatic: questions that explain every wrong option.
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