Question

Regarding Credit Default Swaps (CDS), explain the meaning of the following:a. reference entity b. reference obligation c. protection seller d. protection buyer

Answer 1

Credit default swaps (CDS) are a type of insurance against default risk by a particular company. The company is called the reference entity and the default is called credit event. It is a contract between two parties, called protection buyer and protection seller. Under the contract, the protection buyer is compensated for any loss emanating from a credit event in a reference instrument. In return, the protection buyer makes periodic payments to the protection seller.

In the event of a default, the buyer receives the face value of the bond or loan from the protection seller. From the seller’s perspective, CDS provides a source of easy money if there is no credit event.

a. Reference Entity: A CDS is linked to a reference entity, usually a government backed corporation. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, seller may charge a premium amounts constituting the 'spread' to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. Simply, the reference entity is the organization that issued the reference asset (like bond or credit) that, in turn, is the subject of a credit derivative.

b. Reference Obilgation: A reference obligation is a specially designated debt obligation upon which the credit default swap, is based and is issued by the reference entity. Reference obligation is usually an bond or credit granted.

c. Protection Seller: The protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction in case of any default by the reference entity in respect of reference obligation.

d. Protection Buyer: The protection buyer is the person who makes periodic payments to the protection seller. In return, he is compensated for any loss emanating from a credit event in a reference instrument.