In a CDS, a party known as the protection purchaser (a.k.a. buyer) makes one or more payments to a counterparty known as the protection seller. In return, the protection seller commits to make a payment to the protection buyer following the occurrence of any adverse credit event occurring at the underlying reference entity, entities, or security underlying the CDS. In this chapter, we provide a basic overview of the universe of CDS products and the aggregate activity in the CDS marketplace.
1.1 Primary CDS Product Types
At a high level, we can categorize CDS products based on the source of the credit exposure underlying a CDS from which the cash flows and value of the CDS are derived. From that perspective, there are three main types of CDS products: (i) single-name CDSs; (ii) multi-name CDSs; and (iii) asset-backed CDSs . These three CDS product types are discussed briefly in the sections below and in more detail in Chapters 2 and 3, 4, and 5, respectively.
1.1.1 Single-Name CDSs
In a single-name CDS, the cash flows and value of the CDS are based on the credit quality of a single entity, such as a corporation, sovereign, or municipality. 1 In credit derivatives parlance, such a “reference name” (a.k.a. “name” or “reference entity”) refers to a legal entity that borrows by issuing debt securities or entering into bank loans that expose lenders to at least some credit risk, such as the risk of a partial or total default on a required interest or principal payment. The specific liabilities of the reference entity underlying a single-name CDS may include all or most of the debt securities issued by the reference entity (see Chapter 2), or, in the case of loan-only CDSs (“LCDSs”) , a specific set of loans or a loan facility outstanding at the reference name (see Chapter 3).
1.1.2 Multi-Name CDSs
In a multi-name CDS , the value and cash flows of the CDS are based on the credit risk of more than one underlying reference name. Multi-name CDSs can generally be classified as either portfolio/basket CDSs or index CDSs . In the case of index CDSs, the underlying reference portfolios comprised of multiple reference entities can either be based on whole portfolios or tranched portfolio exposures.
1.1.2.1 Portfolio and Basket CDSs
The most basic form of a multi-name CDS is a contract for which the protection purchaser is compensated for credit-related losses on any/all reference entities in the underlying reference portfolio. For example, a portfolio CDS based on a specific basket of 100 bonds —each of which has a par amount of $1000—provides as much as $100,000 of protection to the CDS protection purchaser, which is paid out when all 100 bonds default with no actual/expected recovery amounts. If the actual/expected recovery amounts (see Sect. 2.1.5 of Chapter 2 for a discussion of the distinction between the two) are not zero, the protection purchaser of such a whole-portfolio receives compensation upon the occurrence of adverse credit events on each and every underlying reference name based on the par values and actual/expected recovery rates of the borrowings underlying the reference names in the portfolio CDS.
Such portfolio CDSs, however, can be very expensive because the protection purchaser is paying for protection from the risk of adverse credit events on potentially all of the names in the reference portfolio. As such, many multi-name CDSs are tailored to the risk management needs or investment objectives of protection purchasers. Specifically, protection purchasers often choose to purchase protection on a subset of the names in the reference portfolio or on a subset of the total underlying credit-related losses. By reducing the scenarios and/or amounts payable by protection sellers to protection purchasers, such tailored multi-name basket CDSs are generally less expensive than full protection purchased on all names in the reference portfolio.
Portfolio and basket CDSs are discussed in more detail in Sect. 4.1 of Chapter 4.
1.1.2.2 Index CDSs
An index CDS has cash flows and a value tied to the credit risk of an index or portfolio of multiple reference entities that satisfy certain criteria articulated by the index provider. Index CDSs may have cash flows that are either based on the entire value of an index or the values of an index over specific ranges of losses in index values (the latter of which is discussed in Sect. 1.1.2.3).
In a traditional or whole-portfolio index CDS, the protection purchaser makes periodic payments to the protection seller (including perhaps an up-front payment) in return for payments from the protection seller based on declines in the value of the underlying index (resulting, e.g., from credit events occurring at one or more of the underlying reference names). Index CDSs can be based either on multiple reference names or multiple reference assets (as discussed in Chapters 4 and 5, respectively).
As a simple illustrative example, suppose an index CDS is based on the values of senior debt securities (or single-name CDSs on the corresponding reference name issuers) of 100 different reference entities, each of which issues $1000 in a single class of bonds. Suppose further that the initial value of the index is 100, the notional amount of an index CDS based on that initial index value is $100,000, and (by necessity) the multiplier that determines the cash flows on the index CDS is $1000. For each one-point decline in the index, the protection purchaser receives $1000. The maximum payout on such a CDS—which is sufficient to cover defaults with no expected or actual recoveries on all the underlying bonds—is $100,000.
1.1.2.3 Tranched Index CDSs
Unlike a whole-portfolio index CDS, a tranched index CDS enables credit protection purchasers to buy protection on specific tranches (from the French word meaning “slices”) of the underlying index. These tranches are usually specified based on the amount of cumulative default losses or declines in value in the underlying index and reference portfolio.
For the same reference portfolio described in the previous subsection for a traditional whole-portfolio index CDS, suppose now that two tranched CDSs are offered, each of which has a notional amount of $50,000 and an index multiplier of $1000. Both CDSs are based on the same index and reference portfolio. The subordinated tranched CDS is exposed only to losses on the underlying index of up to $50,000 (i.e., declines of as much as 50% in the index), whereas the protection purchasers in the senior tranched index CDS are compensated only for more than a 50% decline in the index (i.e., losses of greater than $50,000 resulting from declines in the index times the multiplier).
A numerical example may be useful to distinguish the traditional and tranched index CDSs using the above reference portfolio and tranching scheme. Specifically, suppose the index declines by 10% from 100 to 90. The protection seller in the traditional index CDS makes a payment and realizes a loss of $10,000—i.e., 10% of the notional amount of the CDS. On the tranched index CDSs, the junior tranche CDS protection seller absorbs the entire $10,000 loss, which is 20% of the notional amount of the contract. The senior tranched index CDS protection seller, however, is unaffected. Protection sellers on the senior tranche of the reference index only experience losses when the index declines by at least 50% (at which point protection sellers have paid the maximum amounts to junior CDS protection purchasers).
Index and tranched index CDSs are explained in greater depth in Sects. 4.2 and 4.3 of Chapter 4, respectively.
1.1.3 Asset-Backed CDSs
The third CDS product type is a CDS based on the credit quality of a specific underlying asset or security. Unlike single-name CDSs that are related to a potentially large number of securities or loans issued by a single reference entity and multi-name CDSs that are based on a universe of securities or loans issued by two or more reference names, the credit exposure on which the cash flows and value of an asset-backed CDS are based is determined by the cash flows and/or value of the single specific underlying reference asset or security.
Asset-backed CDSs (“ABCDSs”) are fundamentally distinct fro...