Protection buyer

CDS premiums are above zero As we know the CDS price represents a premium paid by the protection buyer to the protection seller. The protection seller, or the bank, will expect a premium, that is a positive CDS basis over the interbank curve ... 

Market demand Strong market demand from the protection buyer will increase the basis and vice versa ... 

Credit derivative transactions involve both a protection buyer and protection seller. Banks currently act as either buyers or sellers of credit protection in a transaction. Insurance companies are also active in the credit derivatives market as sellers of credit protection. 

The payout to the protection buyer is zero if there is no credit event, or in the event of a credit event such as bankruptcy, par value less the recovery rate. 

Cash settlement represents another method of settling credit derivative transactions. In cash settlement, the protection buyer will receive an amount based on the difference between par and the valuation of the reference asset at a given valuation date, as agreed in the credit default swap contract. 

The legal department of most firms that buy or sell credit derivative instruments carefully monitor the terms of the transaction and in particular will focus on any nonstandard terms. In most cases the market will trade on standard ISDA documentation (terms and definitions). Sources of dispute, which are rare, may arise on the actual contract terms the nature of credit events, the obligation selected by the protection buyer for delivery. 

A total return swap (TRS) is a derivative instrument that allows the protection buyer to swap the total economic return of an asset (e.g., loans or securities) for fixed or floating interest payments. 

In the event of default the protection buyer would be compensated for any loss in value as a result of a credit event affecting the market value of the reference asset. 

In some versions of a TRS the actual underlying asset is actually sold to the counterparty, with a corresponding swap transaction agreed alongside in this type of TRS, the protection seller will make an upfront payment for the market value of the reference asset to the protection buyer. Yet another variation involves no change in physical ownership but still involves an upfront payment of the market value of the reference asset an example of this kind of TRS is described in Exhibit 21.4. On occurrence of a credit event the TRS will be terminated using physical settlement, so that the reference asset is delivered to the protection seller. 

Exhibit 21.4 illustrates a generic TR swap. The protection buyer has contracted to pay the total return on a specified reference asset, while simultaneously receiving a LIBOR-based return from the protection seller. The reference or underlying asset can be a bank loan such as a corporate loan or a sovereign or corporate bond. The total return payments include the interest payments on the underlying loan as well as any appreciation in the market value of the asset. The protection seller will pay the LIBOR-based return it will also pay any difference if there is a depreciation in the price of the asset. The economic effect is as if this entity owned the underlying asset, as such TR swaps are synthetic loans or securities. 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

In a credit default swap, the protection buyer is effectively long a delivery option. This delivery option gives the protection buyer the opportunity to deliver the cheapest to deliver asset to the protection seller. 

Gup and Brooks (1993) noted that swaps credit risk, unlike their interest rate risk, could not be hedged. That was true in 1993. The situation changed quickly, however, in years following. By 1996 a liquid market existed in instruments designed for just such hedging. Credit derivatives are, in essence, insurance policies against a deterioration in the credit quality of borrowers. The simplest ones even require regular premiums, paid by the protection buyer to the protection seller, and make payouts should a specified credit event occur. 

The credit derivative can be tailored to the requirements of the protection buyer, as opposed to the liquidity or term of the underlying loan. 

Because this is different from the fixed premium, an up-ffont payment is made between the protection seller and protection buyer, which is the difference between the present values of the fixed premium and the current market premium. 

From Figure 10.23 we see that the one-off payment for this deal is EUR 27,280. The protection seller, who will receive 40 basis points quarterly in arrears for the life of the deal, pays this amount at trade inception to the protection buyer. ... 

The one-off payment reflects the difference between the prevailing market rate and the fixed rate. If the market rate was above 40 basis points at the time of this trade, the protection buyer would pay the protection seller the one-off payment reflecting this difference. 

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