forwards. In a credit default swap, one party will make a
series of fixed payments to another party in exchange for a
payment that’s conditional upon the occurrence of a specified
credit event such as a default.
For example, Alpha Co. may hold $10 million in a particular issue of a Big Bank Inc. bond security that matures in five
years. Alpha may want to hedge against the possibility that Big
Bank will default on this bond. If so, Alpha (the protection buyer) may enter into a credit default swap contract with Beta Co.
(the protection seller), in which Alpha will pay Beta $200,000
annually (typically stated as 200 basis points on $10 million
notional value, and usually paid in quarterly installments) in
exchange for conditional payment of up to $10 million from
Beta to Alpha in the event
Big Bank defaults on the
bond issue. If Big
Bank doesn’t default within the
Types of Derivatives
Credit spread
forwards
Futures
Options
Credit
Derivatives
Forwards
Swaps
Credit spread options
Credit Default options
total return swaps
Credit Default swaps
five-year term, the credit default swap contract will expire, and
Beta will have made $1 million total. If Big Bank defaults on
this bond at any point during the five-year term, Beta will pay
Alpha $10 million, less the market value of the bond, and future
premium payments from Alpha to Beta will cease.
Figure 1 (Page 40) displays hypothetical cash flows under
several illustrative scenarios. Although a detailed description
of the valuation of credit default swap contracts is beyond my
scope here, Figure 1 highlights some of the key factors needed
for this valuation. These include:
■ Amount and timing of all premium-leg cash flows;
■ Probabilities of a credit event over the term of the
contract (often estimated based on credit spread curves);
■ Recovery rates (i.e., the difference between the notional
amount and the market value of the asset);
■ Discount factors to reflect the time value of money;
■ Adjustments to reflect the creditworthiness of the
protection seller.
contractual Differences
To actuaries and other insurance professionals, credit default swap contracts seem similar to insurance contracts
in which a policyholder pays a premium (or series
of premiums) to an insurance company in exchange for a (usually larger) payment upon the
occurrence of a specified insurable event.
Further, for the most part, credit default
swap contracts provide the same default
protection that financial guarantee insurance contracts provide.
With that said, differences between the protection and terms
offered in otherwise comparable
credit default swap contracts and
financial guarantee contracts
can be significant. For instance,
credit default swap contracts
frequently are structured
so that a full settlement
is made of the notional
amount (less market value)
upon the occurrence of the
credit event, regardless of
when the bond actually
matures. On the other
hand, financial guarantee insurance contracts
don’t accelerate payments but pay interest
payments and principal return over the
remaining term of the
bond. Since insurance
risk includes both underwriting and timing
risk, it could be argued
