| Stephen Stonberg | ||||||
Credit derivatives lie at the heart of the structured credit market and nearly all credit derivatives are based on credit-default swaps.
These instruments are often poorly understood by outsiders. But a plain-vanilla single-name credit-default swap is a very straightforward contract. The complications arise when the swaps are embedded in larger financial structures or are linked to more than one name.
A credit-default swap works like an insurance policy. A protection buyer, most often a bank that owns a loan or bond it wants to hedge, pays an annual premium to a protection seller. In return, the protection seller commits itself to making a one-off payment if the reference credit defaults on any of its debt. The premium is calculated as a percentage of the underlying asset.
Last month, for example, it cost around 75 basis points to buy protection on Ford in a five-year contract - the most liquid maturity.