Set out what credit derivatives are and their main features
The idea
A credit derivative transfers the credit risk of a reference entity from one party to another without transferring the underlying debt. The main example is the credit default swap. 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. A rating downgrade alone is not a credit event. The protection buyer is short credit risk and the seller is long it, much like a bondholder. Single-name CDS reference one issuer, while index CDS cover a portfolio of names and are used to hedge or take broad credit exposure. If the reference entity's credit quality worsens, spreads widen and an existing protection buyer's position gains value. Lenders use CDS to hedge loans they wish to keep on the balance sheet.
A practice question
In a credit default swap, the protection buyer:
- pays a periodic premium to the seller — correct
- receives a periodic premium from the sellerWhy not: Reverses the roles; the seller is paid for bearing the credit risk.
- must own the reference entity's bondsWhy not: A CDS can be bought without holding the underlying debt.
The buyer pays the CDS spread and in return is compensated by the seller if a credit event occurs on the reference entity.
A harder one
Which of the following would NOT normally be a credit event under a credit default swap?
- The issuer's failure to pay interestWhy not: Failure to pay is a standard credit event that triggers the swap.
- The issuer's filing for bankruptcyWhy not: Bankruptcy is the classic credit event in CDS contracts.
- A downgrade of the issuer's rating — correct
Credit events include bankruptcy, failure to pay and, in some contracts, restructuring. A downgrade affects the CDS spread but does not by itself trigger payment.
The hardest tier
An investor bought five-year protection on an issuer at a spread of 150 bp. The issuer's credit quality deteriorates and the spread on new contracts rises to 250 bp. The investor's position has most likely:
- lost valueWhy not: That is the seller's result; the buyer locked in cheap protection that is now worth more.
- gained value — correct
- not changedWhy not: A CDS position is revalued as spreads move, even without a credit event.
Protection now costs 250 bp but the investor pays only 150 bp. The present value of that 100 bp saving is a gain to the protection buyer and a loss to the seller.
In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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