An investor who wants to take a view on France Telecom might sell credit default swap protection. In May 2006, dealers quoted five-year credit default swap spreads on France Telecom at 37/39 basis points (bp, hundredths of a percentage point).
This means the dealer quotes 37bp for a trade where the investor sells five-year protection and the dealer buys protection, and 39bp for a trade where the investor buys protection. (The difference between the two quotes is known as the ‘bid-offer spread’.)
On a typical trade size of €10 million, the protection seller would receive €37,000 a year, usually in four quarterly payments. Conversely, the investor could buy protection for 39bp, paying €39,000 a year.
If France Telecom defaults during the life of the trade and, following the default, the value of the company’s debt falls to 40% of face value (the ‘recovery rate’), the protection seller will compensate the protection buyer for the €6 million loss.