CDS takes possession of the defaulted loan or its market value in cash. Credit default swaps in their current form have existed since the early 1990s, and increased in use in the early 2000s. CDS data can be used by financial professionals, regulators, and the media to monitor swap in forex means definition the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies.
Courts may soon be following suit. Some claim that derivatives such as CDS are potentially dangerous in that they combine priority in bankruptcy with a lack of transparency. Buyer purchased a CDS at time t0 and makes regular premium payments at times t1, t2, t3, and t4. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t5, t6 and so on until the end of the contract at time tn.
However, if the associated credit instrument suffered a credit event at t5, then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller. A CDS is linked to a “reference entity” or “reference obligor”, usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the “spread” charged by the seller to insure against a credit event.
A default is often referred to as a “credit event” and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower’s credit rating. CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration. In this way, a CDS is similar to credit insurance, although CDS are not subject to regulations governing traditional insurance. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection.
If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. CDS can act as a hedge. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. Risky Corp defaults there is usually some recovery, i.