The credit default swap creates no legal relationship between the reference entity and either of the counterparties, only between the two counterparties. ‘Confirms’ are used to document the trade and confirm the terms and conditions agreed by both parties.
The confirms contain a list of definitions that determine, among other things, the credit events that will trigger settlement, the obligations observed to determine whether a particular type of credit event such as failure to pay has occurred, the form of settlement, and the bonds and loans that may be delivered if the contract is physically settled. The definitions and the confirm template are drawn up periodically by Isda. The most recent are the 2003 credit derivative definitions (see page 69).
By convention, there is a standard set of choices from the menu for each type of credit (for example North American high yield corporate, Asian sovereign, European investment grade corporate or Japanese corporate). Prices are quoted assuming that this market standard documentation will be used. However, counterparties sometimes agree to trade on non-standard terms.
Credit events (or defaults) are precisely defined in a credit default swap. The definition of credit events can make a big difference to the value of the credit default swap. Different types of credit events are used as the market standard for different types of credits (see page 71). For example, North American high yield corporates trade with only two credit events: bankruptcy and failure to pay, while investment grade credits in North America can also be triggered by some types of debt restructuring.
The notional size of a credit default swap on an investment grade credit is typically $10 million or €10 million, although US investment grade names often trade in sizes of $20 million. For high-yield names, typical trade sizes are smaller, usually $5 million or less.
The quoted price of a credit default swap is the annual premium or coupon expressed as a proportion of the trade size (or notional) in basis points. This figure is commonly referred to as the ‘spread’ of the credit default swap, by analogy with a bond’s spread over Libor. In most credit default swaps, the premium is fixed for the life of the trade. (The main exceptions are constant maturity credit default swaps – see page 60).
Single-name credit default swaps can be for any term agreed at the outset by the counterparties. However, the majority of trades are for one of a few standard maturities. Originally, most credit default swaps were five-year trades. However, by early 2006, three, seven and 10-year trades had also become popular.
Credit derivatives can be funded or unfunded. In an unfunded trade, as described above, the protection seller makes no payments until there is a default. Alternatively, single-name credit default swaps can be funded by repackaging them as credit-linked notes.
Even though single-name credit default swaps are unfunded, most counterparties generally collateralise their contracts with each other through a credit support annex (CSA), which is effectively a margining arrangement. As a protection buyer’s credit exposure to its counterparty increases beyond a certain threshold, the counterparty has to post collateral to offset the protection buyer’s counterparty credit risk.
Most trades with hedge funds are transacted under a CSA. For example, a hedge fund might trade a $10 million single name default swap with a dealer and put up $1 million to collateralise the trade. If the market value of the trade moves against the hedge fund beyond a certain threshold, say $2.5 million, the dealer will ask it to post additional collateral to cover the increased risk.