Lesson 6 of 7 · 11 min
Credit default swaps
A credit default swap lets one party pay a fixed spread to another in return for compensation if a third-party issuer suffers a credit event, transferring default risk without trading the bonds.
In short
- A credit derivative pays off on the default risk of an issuer or a group of issuers. The main one is the credit default swap (CDS).
- The protection buyer pays a fixed periodic CDS spread; the protection seller pays LGD × notional if a credit event (bankruptcy, failure to pay, involuntary restructuring) occurs.
- A CDS is a contingent claim with swap-like features: worth zero at inception at the par spread, with a notional that is not exchanged.
- The buyer is short credit risk and gains if spreads widen; the seller is long credit risk, like owning the issuer's bond.
- MTM change ≈ change in CDS spread × effective duration × notional.
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