If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t5, t6 and so on until the end of the contract at time tn. However, if the associated credit instrument suffered a credit event at t5, then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller. A CDS is linked to a “reference entity” or “reference obligor”, usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the “spread” charged by the seller to insure against a credit event.
A default is often referred to as a “credit event” and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower’s credit rating. CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration. In this way, a CDS is similar to credit insurance, although CDS are not subject to regulations governing traditional insurance. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated.
CDS can act as a hedge. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. Risky Corp defaults there is usually some recovery, i. The “spread” of a CDS is 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. For example, if the CDS spread of Risky Corp is 50 basis points, or 0. All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison.
CDS contracts have obvious similarities with insurance, because the buyer pays a premium and, in return, receives a sum of money if an adverse event occurs. However, there are also many differences, the most important being that an insurance contract provides an indemnity against the losses actually suffered by the policy holder on an asset in which it holds an insurable interest. By contrast a CDS provides an equal payout to all holders, calculated using an agreed, market-wide method. Insurers manage risk primarily by setting loss reserves based on the Law of large numbers and actuarial analysis. CDS the contract needs to be unwound.