A Credit Default Swap (CDS) Coursework Example | Topics and Well Written Essays - 2250 words

A Credit Default Swap (CDS) - Coursework Example The creditor must make periodical payments (which are taken to be insurance premium) to the insurer, and the insurer will pay the creditor in case the there is default. The fixed periodical payments made by the creditor or the buyer of a Credit Default Swap are known as the CDS fee or commonly referred to as CDS spreads. The buyer of the Credit Default Swap can only receive the exact value of the credit or loan and can not be compensated beyond that value. The seller of the Credit Default Swap (or the insurer) takes possession of the defaulted credit or loan, obtains right of ownership and can therefore sue to recover the credit. The value of the spreads to be paid should be determined so that the buyer of the Credit Default Swap can pay the correct value for the Credit Default Swap. Consider an example where a buyer of Credit Default Swap enters a five year contract to pay CDS spreads on Ford Motors credit with a principal of $10 million at 300 basis points. This means that the buye r pays $300,000 per year and obtains the right to sell bonds worth $10 million issued by Ford of that value in the event of a default by Ford. This thesis is divided into three parts which cover the topic in Credit Default Swap spreads in details. ... Bonds with AAA rating are considered to have almost no chance of default and its CDS spreads are expected to be lower compared to D rating which have a very high risk of default and its CDS spreads expected to be far more expensive. Probability Model There are other quantitative methods that can be employed to determine CDS spread to be paid. The probability model is one of the quantitative methods. This method recommends that credit default swaps should trade at a significantly lower spread than company bonds. The price of a Credit Default Swap is determined using a representation that considers four factors which are; issue premium, recovery rate (which is the percentage repaid in the event of default), credit curve and LIBOR curve. The price of a Credit Default Swap would be determined by adding the discounted premium payments. To explain the probability method better, imagine a case of one year Credit Default Swap which will be effective on lets say date t with a quarterly spread payment taking place on dates t1, t2, t3 and t4. If the nominal for the Credit Default Swap is N and the issue premium is C, then the value of the periodical spreads is given by the formula NC/4. If we imagine the default can only happen on one of the payment dates, then the swap agreement can end when; it lacks a default within agreed time and so the spread payments are made and the agreement endures until maturity date or, a default takes place either on first, second, third or fourth compensation date. The price of the Credit Default Swap is now determined by assigning probabilities to the five probable results. Labor Rate Labor rate can also be employed to benchmark the price for Credit Default Swap securities of a listed company. Labor is the interest fee which