1. CREDIT DEFAULT SWAP
FAHAD . P

2. Objective of the study
To study how CDS can be used for
hedging the default risk or counter
party risk.

3. Introduction
 Credit default swaps (CDS) are the building
blocks in the credit derivatives market and
represent half of its volume.
 CDS is bilateral contract between a
protection buyer and protection seller that
exchanges the credit risk or a specific issuer
(reference entity).
 The protection buyer (short the credit) pays a
premium to the protection seller (long) to
assume the risk associated with particular
credit event.
 Credit events are typically defined to include
bankruptcy, material default, and debt
restructuring for a specified reference asset.

4. Meaning
 A credit default swap (CDS) is
a financial swap agreement that the
seller of the CDS will compensate the
buyer in the event of a loan default or
other credit event. The buyer of the CDS
makes a series of payments (the CDS
"fee" or "spread") to the seller and, in
exchange, receives a payoff if the loan
defaults.
 in the event of default the buyer of the
CDS receives compensation (usually
the face value of the loan), and the seller
of the CDS takes possession of the
defaulted loan.

6. CDS Terms
 In the standard CDS, payments are usually
made in arrears either on a quarter,
semiannual, or annual basis.
 The par value of the bond or debt is the
notional principal used for determining the
payments of the buyer.
 In the event of a default, the payoff from the
CDS is equal to the face value of the bond (or
NP) minus the value of the bond just after the
default.
 The payments on a CDS are quoted as an
annual percentage of the NP. The payment is
referred to as the CDS spread.

7. CDS Uses
 CDS are used primarily to manage the
credit risk on debt and fixed-income
investment positions.
 Default or credit event – Examples
include ;
◦ Bankruptcy
◦ Failure to pay
◦ Restructuring
◦ Repayment Acceleration on Default (cross
default clauses)
◦ Repudiation

8. Buyers of CDS Protection

9. Credit Derivatives by region
43%
5%10%
39%
3%
London Europe ex-London Asia/Australia US Other

10. Motivations for using Credit Default
Swaps
Advantages :
1. Trading/ market making
2. Product structuring
3. Hedging trading instruments
4. Active portfolio/ asset
management
5. Management of economic
capital
6. Management of regulatory
capital
7. Management of individual credit

11. Disadvantages :
1. Lack of client knowledge of the
product
2. Regulatory constraints
3. Systems / Infrastructure
4. Pricing – lack of data
5. Lack of agreed accounting
conventions
6. Lack of homogenous
documentation
7. Lack of market liquidity and depth

12. Working or Usage of CDS :
 As Hedging Risk
 As Speculation

13. CDS as Hedging risk
 Credit default swaps are often used to
manage the risk of default that arises
from holding debt. A bank, may hedge
its risk that a borrower may default on
a loan by entering into a CDS contract
as the buyer of protection. If the loan
goes into default, the proceeds from
the CDS contract cancel out the
losses on the underlying debt

14. HEDGING
Notional 10000000
Premium (%) 2%
Premium (Rs) 200000
Duration 5 year
quarterly payment 50000
IF DEFUALT HAPPENS :
PB receive from
counter party 0
PB receive from PS 10000000
Premium paid (5 yr) 1000000
Net Amount 9000000

15. IF NO DEFUALT HAPPENS :
END OF 5 YEARS
PB will receive end of 5
years 10000000
premium paid for CDS to
PS 1000000
Net amount 9000000

16. Speculation
 An investor might believe that an
entity's CDS spreads are too high or
too low, relative to the entity's bond
yields, and attempt to profit from that
view by entering into a trade.

17. SPECULATION
NOTIONAL AMOUNT 10000000
DURATION OF CDS 2 YEAR
SPREAD 500000
IF DEFUALT
HAPPENS :
AFTER 1 YEAR
PREMIUM PAID 500000
SPECULATOR RECIEVES 10000000

18. IF NO DEFUALT :
PREMIUM PAID 1000000
PROTECTION BUYER'S LOSS 1000000
PROTECTION SELLER GAIN 1000000

19. CONCLUSION
 CDS Is The One Of The Best
Instrument Available In The Market
For Any Business Entity Against
Default Risk , It Will Help Them To
Reduce Their Counter Party Loss
Rather Than Making Profit.