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Real Estate Research starts here! | International Commercial Property | Commercial Law Firms | International Real Estate |      Jan 17, 2019

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credit default swap (CDS)

A form of insurance against the risk of default on a debt. For example, a contract that will pay the insured ('protection buyer') if a company ('the reference entity') defaults on its debt or a bond. This is not strictly a 'swap' but an insurance contract where a premium ('fee' or 'spread') is paid for insurance against a specified potential loss. Payment under the contract does not take place until an event of default (a 'credit default) has occurred, such as a failure to make payments on the bond for a specified period of time or a bankruptcy. As a rule, the insurer ('protection provider') undertakes to cover the risk on a range of diversified debts or obligations, such as the debts of several companies or a number of bonds. In this way it spreads the risk as with any insurance policy. The 'premium' for the insurance is quoted as a number of basis points (bp) (100bp = 1%), so if the cost of insuring $20m of bonds is 200bp the insured must pay a fee of $400,000 per annum to maintain the policy. In the event of 'credit event' the protection seller will pay the buyer the lossed value of the debt or bond. This may be the total amount (e.g. $20m) or the face value of the bond, less any residual market value of the bond (e.g. if the bonds can be sold for 30¢ on the dollar, $20m less 30% of $20m = $12m). The protection buyer and protection seller are called CDS counterparties.
In the case of a colleralized security, unlike a regular insurance policy, the insurer does not pay for the total loss when an event of default occurs, but as and when each part of the underlying debt defaults (i.e. as each underlying mortgage loan defaults) and only after taking in to account any part of that loan that may be recovered from the borrower. Sometimes called 'credit default options'. See also collateralized-debt obligation, derivative.

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