What are the attractions and weaknesses of a credit default swap (CDS) and how it operates? Can you please provide me with an example? I am very confused with this topic!!
A CDS has two counter-parties a buyer of CDS and the seller of this CDS
Now the buyer could own any asset for e.g. a bond of a Company than in order to protect himself against a default by the bond the buyer buys a CDS from the seller. SO that if at all bond defaults at any future date than the buyer receives the difference between the face value and the market value of the bond. The buyer in return has to pay the seller credit spreads every period say a yearly. The seller has the obligation only at the time of default of the bond but the buyer needs to pay the spread till the life of the CDS.
e.g. suppose that corporate bond owner buys a CDS to protect against default by the bond. Then suddenly after some time due to unforeseen reason the bond defaults, than suppose the bond trades at market value of 50 but the face value is 100 so that under physical settlement the buyer receives the face value of 100 and give bond to the seller of CDS thereafter seller sells it at the market price of 50 thereby suffering a loss of 50. Similarly in cash settlement the buyer of CDS receives the difference between the market value and the face value of 50 in cash but still own the bond. Thus the CDS buyer has protected himself against the default by the bond in return for credit spread payments periodically. the same logic applies to any asset so that if there is default on asset the CDS buyer is protected from the default and CDS seller is facing the risk of default.
hope u understood
thanks
This site uses cookies to help personalise content, tailor your experience and to keep you logged in if you register.
By continuing to use this site, you are consenting to our use of cookies.
