Explain credit default swaps (CDS), covering index CDS as well as single-name CDS, and the terms that specify a particular CDS contract
The idea
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. Single-name CDS reference one entity; the contract names a reference obligation that sets the seniority covered, and the payoff is based on the cheapest-to-deliver obligation of that seniority. Index CDS cover a basket of equally weighted names; when one defaults, the seller pays that name's share of notional times its loss, and the index continues with a smaller notional. Contracts specify notional, maturity, standard coupon, seniority and the credit events covered. Upfront payments settle the gap between spread and coupon.
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- Explain what counts as a credit event for CDS and how CDS contracts are settled
- Explain the principles behind how the market prices CDS and the factors that affect that pricing
- Explain how CDS can be used to manage credit exposure and to take views on moves in the level or shape of the credit curve
- Explain how CDS can exploit mispricing between distinct markets, for example loans, bonds, equities and instruments linked to equity