Credit default swap (CDS)

A CDS is a bilateral contract between two counterparties. The protection buyer is buying insurance: he/she pays premiums in exchange for a payoff in case there is a CREDIT EVENT (a trigger)

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Education

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• Excel
• Quant

[OrmEmber]

Thanks Bionic Turtle! Sometime if you could explain the equation "1-recovery rate" that would be great. But at least it makes a little sense now.

[bionicturtledotcom]

Thank you OrmEmber. 1 - recovery = loss given default (LGD). If a $100 bond defaults, something is typically recovered. Say $30 is recovered. In a cash settlement, the protection seller pays only 100 - 30 recovered = $70 lost to the protection buyer because the buyer recovers $30. So, the buyer is kept whole with $30 recovered + $70 (=1-recover) = $100

[jaymantis]

So in this example, if I did not own the $100 bond, would i only receive $70 because I wouldn't be entitled to the $30 recovery?

or

would i be required to buy the bond to deliver it to the protection seller?

[bionicturtledotcom]

right, if the contract calls for cash settlement, and you didn't own bond, you'd only receive $70.

Re: would you be required to buy the bond. The cash versus physical has typically been set initially (at the time of contract). Sometimes, a physical can go cash, but ultimately it's contractual.

[lumbage]

Thanks bionicturtle, but I am not sure what you mean by "the cash settlement is meant to arrive at the same place: notional - final post default price." I am a layperson...

[bionicturtledotcom]

for example, bond value = $100. Defaults and triggers CDS payout. Post default bond price = $30 (i.e., recovery estimate is 30%).

Cash settle: CDS protection seller pays $70

Physical settle: CDS buyer delivers ( by first purchasing) defaulted bond worth $30 and receives $100. Net "gain" also = $100 - 30 = $70

[Praske94]

dssds

[agolakchub]

Hello Bionic Turtle. So in essence we can assume that the protection buyer receives 1 - .30 of the total value of the asset the CDS was bought against correct? I.e. the 1 - .30 = .70 and .70 of the $100 value is $70.

So thats all the buyer receives from the protection seller; but, the buyer also recovers $30 worth of the entire value of the bond - equaling the total value of the bond. Is this the basic way it works

[olusolaaboaba]

thanks so much for the explanation.

apart from counterparty risk, what are the other risks that a CDS bears?

[CoolBeansEntertainer]

THUMBS UP IF JOSH SENT YOU HEAR!

[mspencer02]

Wow. I really wish the Fed had taken a look at this before they tried to figure out Lehman's books. It's a simple description of a derivative which few knew about until it blew the economy up.

[zulfi721]

thanks....

[lilsi19]

10/10, very clearly explained thank you

[theartofluv]

Wow, this is much better than go through 500 pages textbook. Thank you Bionic Turtle. You save me a lot of time (5 min vs. hours), and money.

[Ksabrs45]

Great video. You managed to explain what none of my Finance professors at Generic State University bothered to.