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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA

par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010

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2.12.2 Credit Default Swaps (CDSs)

CDS is one of the most common credit derivatives and these credit derivatives are considered as instruments used in moving risk over from one party to another. This is because they are simple in structure and have very flexible conditions whereby banks as well as investors can easily use in hedging their exposure to credit risk. CDS exchanges streams of payments for agreement in repaying the specified notional amount (face value of an asset/instrument used in calculating payments made) if there is a default payment on the loan caused by a `supposed' third party. Bear in mind that, the protection buying price with a CDS is strictly based on basis point spreads (the annual amount the protection buyer must pay the protection seller over the length of the contract expressed as a percentage of the notional amount) with the basis point being just 0.01% of the contract's notional value of the supposed deal because 1 basis point=0.01%. Note that the premium is usually quoted in basis points per year of the contract's notional amount whose payment is made quarterly. For instance, consider the CDS spreads of the risky corporation to be 25 basis points, that is, 0.25% remembering that 1 basis

point=0.01%, then an investor wanting to buy a $10million worth of protection from a triple `A' bank, must be ready to pay the bank $25,000 per year and these payments continue until the CDS contract expires or a default occurs. How CDSs Work

CDSs allow the contracting partners to trade or hedge the risk that an underlying entity defaults. Here, the protection buyer pays a yearly premium until the contract matures. In return, the protection seller assumes the financial loss in case the underlying security becomes insolvent. As a result of this, a CDS contract resembles an insurance policy whereby one side assumes the risk and the other pays an insurance premium. When signing the contract, the protection buyer and seller agree upon a premium which will remain constant until the contract matures and which compensates the protection seller for bearing the risk.

A typical CDS contract, is bounded with some terms and conditions usually documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association (ISDA). In the confirmation, we will have the reference entity specified, be it a corporation or sovereign body generally being identified with outstanding debts plus a reference obligation, usually unsubordinated government bond. Within the confirmation there is a specification of the calculation agent responsible for making the determinations as to successors and substitute reference obligations as well as performing the various calculations and the administrative functions regarding any transaction.

As if that is not enough, in the CDS confirmations, all credit events giving rise to payment obligations by the protection seller and delivery obligations by the protection buyer are being specified. Some of these credit events include bankruptcy with reference to the supposed reference entity and its failure to pay with respect to its direct loan debt. The contract's

effective date and scheduled termination date is always referred to the period over which the

default protection extends. The following diagram illustrates a summary on how CDS works.

Figure 7: A Summary on How CDS Works


Protection Buyer No credit event: no payment

Credit event: payment Protection

Protection Seller

Reference entity

From the diagram above, it is clear that there is a relationship between the protection buyer and seller whereby a premium is paid to the seller. The seller in return is protected because he has an option of repaying or not depending on the state of the financial market. All of these are sealed in the presence of a reference entity which is usually a corporation or a government. CDS simply put, is a contract of protection between two counterparties-the protection buyer and the protection seller. Note that the protection buyer is the one responsible for making the payments to the protection seller but in case of a default, the seller pays the par value of the bond in exchange for any physical delivery of the bond.

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