Financial Technologies

Credit default swaps (default swaps) transfer the credit risk of an issuer from one party to another. The party buying protection pays a premium to the party providing protection; in exchange, the party providing protection agrees to pay an amount to the other party upon the occurrence of a credit event with respect to the issuer.
Default swap contracts have the following important terms:
Reference Debt Obligation.
The default swap contract will define the Reference Debt Obligation. This can be a bond, loan, swap contract, or any debt obligation of the Reference Credit. This section should provide for successors to the Reference Credit as well as a process to choose replacement debt obligations if the Reference Debt Obligation is called, prepaid, or otherwise ceases to exist any time during the life of the contract.

Credit Event or the Event of Default.
There are at least three choices for definition of the Credit Event:
(a) market convention, which is a four-part definition including forced acceleration, payment default, major debt reorganization or a bankruptcy;
(b) an Event of Default under the Reference Debt Obligation; or
(c ) ISDA's draft standard which is similar to (b) but more extensive.
The primary concern of both parties should be to choose a definition that excludes "minor" or technical defaults. The party providing protection would not want a false trigger to cause them to make a payment; likewise, the party buying protection would not want to forfeit that protection on the occurrence of a non-substantive default.
Materiality
. Some transactions require that for a Credit Event to have occurred, a minimum price deterioration (known as a materiality threshold) in the underlying asset should have occurred. This threshold assures the protection buyer that he will not loose the credit protection if the market deems the credit event to be immaterial.
Payout.
Following a credit event with respect to the underlying reference credit, the party providing protection will either agree to buy the underlying asset (if the transaction is physically settled) or will make a cash payment (cash settlement). Cash settlement is typically an amount equal to the par amount of the underling debt obligation less the then current market value of the defaulted obligation, as determined by market bids. Due to liquidity issues after default, physical settlement is the current market standard. An alternative payout structure is a "digital" payout, equal to a fixed amount of the notional, usually 100%.

The premium of a default swap
Price or premium. The party providing the credit protection receives a swap is usually near the asset swap premium. This premium is agreed upon between the two parties and will generally level of comparable cash asset be near spreads achievable in conventional markets for assuming floating rate
exposures on the Reference Credit for the tenor of the default swap.

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Credit derivative instruments are simply financial contracts that facilitate credit risk transfer
Credit derivatives are bilateral financial contracts that transfer credit risk from one counterparty to another. This section offers a brief introduction to each of the main credit derivative products. Credit derivatives take on the form of swaps or options and can be embedded in bonds, notes or securities issued by special purpose vehicles (trusts or companies).

Ccredit derivatives desk is a market maker in the following products:
• Swaps or options with cash flows linked to the default or change in credit spread of an identified asset or basket of assets;
• Total return swaps on bonds, loans, indices or other assets with credit risk; and
• Special purpose vehicle securities (SPVs) that embed credit risk or tranche credit risk by tenor or seniority.
In Table, we show the primary risks that are transferred by a given credit derivative product.

Table : Credit Derivative Products and Risks Transferred
Primary Risks Transferred                  Products
Credit risk                                                  Default Swaps
Credit and spread risks                         Credit Spread Options
Putable, Callable and Remarketed Asset Swaps
Credit, spread and correlation risks            Portfolio Default Swaps
Synthetic CDOs
Credit, spread and interest rate risks             Total Return Swaps
Index Swaps
Synthetic Zero Coupon Bonds Synthetic Callable Bonds
CBOs and CLOs

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