CDS single name
A "single-name" CDS protects against a single asset (e.g., a bond); an "index" 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 bond doesn't default, the protection buyer has lost the stream of spread payments over the swap's life. 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.
The ISDA Triggers
Of course, the definition of default is critical.
The CDS market is over-the-counter (albeit increasingly liquid); as such, two parties can define default to their mutual liking.
But most rely on the 2003 ISDA Credit Derivatives Definitions published by the International Swaps and Derivatives Association.
The ISDA definitions play a key role in the the growth of credit derivatives markets. Standards facilitate transactions.
Under the definition of default, ISDA gives six definitions but the counterparties have flexibility in the specifics (e.g., is there a grace period in the event of failure to pay? If so, what is its length?):
- Obligation Acceleration
- Obligation Default
- Failure to Pay (after a specified grace period)
Note that a ratings downgrade (e.g., S&P or Moody's downgrade) is not on the list. Downgrades are not default triggers.
Also, the restructuring trigger (an "adverse change" in the obligation) is famously controversial.
- Fitch Expands CDS Scores Waters Technology, July 9, 2010