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CREDIT DEFAULT SWAPS (CDS)

The majority of credit derivatives are credit default swaps, or CDSs. The buyer of a credit derivative pays a recurring premium and receives payment equal to loss under default if the underlying asset defaults, or is subject to a credit event that qualifies for triggering the CDS. The derivative has a paying leg and a receiving leg, like a swap. For the buyer of a CDS, the paying leg is the premium and the receiving leg is the payment contingent upon default of the underlying asset. (See Figure 9.1.)

Credit default swap (CDS), protection seller and buyer, and reference asset

FIGURE 9.1 Credit default swap (CDS), protection seller and buyer, and reference asset

TOTAL RETURN SWAPS

A total return swap (TRS) exchanges the total return, current yield plus any change in value, whether positive or negative, between two assets. The exchange of cash flows occurs whether or not there is a default event. The swap exchanges flows and changes in asset value periodically or at some fixed dates.

The buyer of the TRS receives an "algebraic" total return, interest plus capital gain or loss of some specified underlying asset (a bond). When the credit standing of the bond deterio

Two-way flows with a total return swap

FIGURE 9.2 Two-way flows with a total return swap

rates, there is a capital loss for the bond and the TRS seller pays the loss to the buyer, who is protected against such loss. When the credit standing of the bond improves, the buyer pays to the seller the capital gain. This is a "two-way" flow. The buyer of the TRS pays to the seller a fixed premium for the insurance.

The seller of the total return swap is also as the seller of the protection of the buyer of risk. The same terminology as for CDS applies for the buyer of the swap, who is also a protection buyer and a seller of risk. The credit risk buyer gains full exposure to the underlying asset. The risk materializes through a depreciation of value or a default. The buyer of the protection receives the interest while the seller suffers a loss. (See Figure 9.2.)

 
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