First American Bank Credit Default Swaps

1. What is a credit default swap?

A credit default swap (CDS) acts as a financial agreement between two counterparties where the protection seller of the CDS will compensate the protection buyer of the CDS in the event an issuer of bonds defaults in exchange for a regular scheduled fee or premium. Essentially, a CDS acts as a form of insurance for the protection buyer and the protection seller is the insurance agent. A CDS contract is usually defined by a reference entity, a list of credit events, a term or maturity, a reference obligation, and a notional amount. A payment by the protection seller would be triggered by a list of credit events which are agreed upon when the CDS agreement is made. Bankruptcy, failure to pay, obligation acceleration, repudiation, moratorium, and restructuring are common credit events. When a credit event occurs, there are two types of settlement; physical and cash. Physical settlement is when the protection buyer delivers the bond to the protection seller in exchange for the full face value in cash. Cash settlement is when an auction is held to determine bond prices. The protection seller would then deliver to the protection buyer in cash the full face amount of the bond less its current value as determined by the auction. The protection buyer could then in theory deliver the bond to obtain the full value of their investment after the bankruptcy proceedings were held.

2. Why should there be a market for CDS? Who should be the buyers and who should be the sellers of CDS?

One reason for CDS’s is to provide a reduction of credit risk to purchasers of debt. CDS’s were originally created so that banks could shift the credit risk of an issuer to a third party. Also a CDS can used to monitor the credit rating of an entity based on the price for which the CDS trades on the market. Another reason for CDS’s is instead of actually holding